ROTH vs Traditional IRA’s: What’s the Difference?
The ROTH after tax and the Traditional Pre-tax method of saving is almost identical except for one variable, which is a person’s income tax. A person’s income tax rate will be a key factor in deciding which avenue to take, pre-tax or not.
How Are Personal Income Tax Rates Determined?
An income tax rate is based on the amount of taxable income a person brings in. The higher the taxable income, the higher the income tax rate. A person’s filling status, meaning if they have dependents or other deductions, will directly affect the tax bracket a person falls in. More income, or higher wages equals a hirer tax bracket.
Traditional or Pretax IRA/401K Method: How does this benefit me in my higher tax bracket?
Traditional or Pretax IRA method of saving pulls the contributions to the retirement fund before taxes. Only when a person pulls from their IRA, do they pay taxes on their money. This benefits those who want to reduce their income, which in turn reduces their income tax rate. There are a few reasons why a person would choose to deduct their retirement before taxes.
- Reducing taxable income by 10 to 15% or more can reduce the amount of income tax a person pays at the end of year to the IRS. This along with charitable deductions and/or dependents can put a person in a lower income tax bracket and reduce their income tax rate. An example of this is explained below:
Let’s say hypothetically, a family brings in $465,000 a year. In the State of Arkansas, that would place them in a tax bracket of 39.6%. This is equivalent to 46 cents per dollar they earn will go to taxes. This family wants to reduce their tax bracket by having their IRA/401k contribution taken out before taxes, along with any other charitable donations and place them in a lower tax bracket that will reduce the total tax amount.
- A person may realize that when they retire, they will be in a lower tax bracket, and when they pull from their IRA/401K, it will be at a lower income tax rate. An example of this is explained below:
A person’s W2 shows $30,000 – $3,000 = $27,000 (hypothetically, their tax rate is 20%)
For 20 years a person pulls out $3,000 a month before taxes, which now equals $60,000. Their IRA or 401K, the funds have grown as well to equal $150,000. This person is retired, living on a fixed budget and is in a much lower income tax bracket. Now when the person pulls from their IRA/401k, they are paying the taxed amount that reflects their current income tax bracket.
ROTH Taxed Method: How does the taxed IRA help me in my tax bracket?
With the ROTH Taxed Method, a person is paying taxes on the contributed amount to their IRA/401K. It would look like this: $30,000 – $3,000 = $30,000. This is because the contribution amount is being taxed along with the rest of taxable earnings. Again, there are multiple reasons why someone would choose the taxed method of savings.
- Let’s say hypothetically, a family feels comfortable in their tax bracket of 10, 15 or 20%. They have some children living at home and pay a mortgage for which they receive additional tax credits and donate to charities and/or their religious institution. They know that when they retire, they will be in a higher tax bracket because they will have less deductions. Hopefully, their home will be paid for, they will not have children living at home and they could have other investments that count as income.
In that 20 years, they have paid tax on $60,000. That taxed money has grown as well and now equals $150,000.
According to the IRS, the original amount of $60,000 has already been taxed and now there is a growth or gain of $90,000 that is untaxable. This is because the IRS considers these funds to be co-mingled with the original $60,000, and the funds can be pulled out at any time without any additional tax.
- There is a chance that a family’s income could increase or tax laws can change. And at this moment the amount that is being taxed in the allocated tax bracket, they are comfortable with. So, they decide to pay taxes now, instead of later.
Every financial portfolio is unique to each individual situation. If you have more questions regarding the differences between taxed and pre-taxed IRA/401ks or you need some extra guidance with how to save and allocate funds for retirement, please reach out to us.
We are here to assist you with your planning and investing, so you can focus on living.
Contact Hagan Newkirk
Telephone: (501) 823-4637
Visit our Office:
6325 Ranch Drive
Little Rock, AR 72223