4 pink piggy banks lined up

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Would you like to pay $0 taxes when you take money from your retirement account? You can with a Roth IRA.

 

All of us in the Money Maven community like to save money, especially on taxes.   Sometimes we hear of schemes that are too good to be true.  Believe me, this one is true.  There is a retirement account where you pay $0 taxes when you take money out.  The Roth IRA.


The Roth IRA

You have already paid taxes on the money you contribute to a Roth IRA.  Any money you pull out of the Roth IRA in retirement is tax-free!

I attend a strength training class at the Community College gym.  There are a bunch of us in the class that discuss money and investing while we are working out.  Recently, Jim was on the machine next to me.  He had overheard me earlier talking about Roth IRAs. 

Jim pointed out he paid $1,400 less in federal income taxes on his 2022 tax return because he took a deduction for contributing to a Traditional IRA. He asked why would I pay more in taxes and contribute to a Roth IRA.

I replied, pay taxes now or pay 5X more later

Jim is right, there is a tax benefit now for contributing to a Traditional IRA. When looking at Traditional or Roth IRA it is basically a question of pay now or pay later.  Or I should say pay now or pay a lot more later. 

Indeed, Jim may have a $1,400 lower tax bill today only to pay $8,000 more in 20 years when he needs to pull the money out.   That is 570% more in taxes later!

I asked Jim what he plans on doing with the extra $1,400 he is getting in his tax return.  He plans to take a vacation with his tax return.  He is not investing that extra $1,400.  This makes me think that unless you are a very disciplined investor – you will end up with more money with a Roth IRA.

Because of our conversation, Jim has a lot to consider before he makes his 2023 IRA contribution.

Differences in Taxes

Where did the $8,000 figure I mentioned come from?  

According to Investopedia, the average annual return of the S&P 500 since its inception in 1957 is 10.15%.

Let’s say you invested $6,000 in a Roth IRA in 2022.  It is believable you will see the same 10% average historic return of the S&P 500.  In 20 years your $6,000 investment would be worth over $40,000. 

On a side note, turning $6,000 into $40,000 is why we Money Mavens love the power of compound returns and compound interest.  Your money makes money. And the money that money makes, makes money

Because it is in a Roth IRA, all of that $40,000 is tax-free when you withdraw it.  In a Traditional IRA all the gains are taxed at ordinary income rates. Thus $36,000 of the gains would be taxed.  That is almost $8,000 in federal income taxes if you are in the 22% tax bracket.  In addition to that most of us also pay state income tax also.

Roth IRA Contributions

In 2023 you can contribute $7,000 to an IRA, $7,500 if you are age 50 or older. 

Not everyone can contribute to a Roth IRA.  There are restrictions for high earners.  If you are lucky enough to be a high earner you are restricted from making full Roth IRA contributions.  The restrictions begin above $138,000 in modified adjusted gross income in 2023 for individuals and $218,000 for married couples filing jointly

See this page on the Fidelity website for IRA contribution limits and income requirements

IRA Contribution Limits | Fidelity 

If your income is over these limits, you may still be able to use the backdoor Roth IRA. 

Summary

The biggest advantage of a traditional IRA is the upfront tax break. I see it as a great incentive to get people who might otherwise skip saving for retirement to invest in an IRA. You can view the tax savings as reducing the cost of your IRA contributions in the short term. But you will eventually have to face that tax burden in retirement.  Unless you really need those upfront tax savings or you are certain your taxes will be lower in retirement, it’s hard to go wrong with a Roth IRA.

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