The main question when choosing retirement arrangements (IRA, 401(k), etc.) is whether to pay taxes now or pay taxes later. In the “pay taxes now” scenario, you contribute after-tax income to a Roth account and pay no taxes upon withdrawal. In the “pay taxes later” scenario, you contribute pre-tax income (e.g. Traditional IRA), get a tax deduction today, and pay taxes upon withdrawal.
Let’s take the simple example of IRA contributions. Assume you are deciding what to do with $6,000, which is the 2020 IRA contribution limit for individuals under 50 ($7,000 for 50 and over).
|Initial Investment ||$ 3,900 || $ 6,000 ||$ 6,000 |
|Final value Pre-Tax ||$ 22,400 ||$ 34,461 ||$ 34,461 |
|Opportunity Cost ||$ (10,567) |
|FINAL POST TAX VALUE
Option 1 (No IRA): In this example you are starting off with a smaller investment because you pay income tax on the $6,000 you earn. This path results in the lowest final value because it’s taxed a second time as capital gains upon liquidation.
Option 2 (Traditional IRA): In this example you contribute $6,000 pre-tax to a Traditional IRA. You get a tax deduction today and defer taxes until withdrawal (30 years in this example).Withdrawals are then taxed as income.
A Traditional IRA is especially advantageous when:
- You are confident you’ll be in a lower tax bracket at retirement.
- You are a high earner in a high-tax state but plan to retire to a low-tax or no-tax state and live off your savings. (Why do you think so many New Yorkers historically have retired to Florida?)
Option 3 (Roth IRA): In this example you contribute $6,000 after tax to your Roth IRA. This investment grows tax free, and will not be subject to tax upon withdrawal; however, there is an opportunity cost of missing out on the Traditional IRA tax deduction up front. The assumption in calculating the final value is that you could have taken your tax deduction up front and invested that amount in a regular account.
A Roth IRA is especially advantageous when:
- You are in the accumulation phase of your life and career and are confident that you will retire with a higher net worth than what you have today.
- You are not currently in the top income tax bracket or you currently live in a low-tax or no-tax state.
Additional Roth IRA benefits:
- No required minimum distributions when you reach age 72. This means your account can continue to grow tax free.
- Tax-free inheritance for your heirs.