GTGWAS - Step 2 Topic C

Posted 1 month ago in Economics and Trade.

Tax Deferred Vs Tax Free... Pay Taxes Now or Pay Taxes During Retirement

GTGWAS - Step 2 Topic C

In planning for retirement one of the main considerations is do I pay taxes now or do I pay them later.  Do I use 401K and Traditional IRA now and deduct my contributions from my taxes now, let the account grow tax deferred and pay taxes as I withdraw at retirement or do I use the Roth IRA and pay the taxes on the contributions now and at retirement take tax free withdrawals?

What we have been brainwashed into believing is that its always better to pay taxes at retirement because you will be in a lower tax bracket.  For many it is true that at retirement you will not have the assets you need to retire at an income and lifestyle equal to or greater than when you were working.  You will be struggling to survive on social security, maybe a pension and some savings.  So paying taxes later is a good idea.  But if you have planned everything properly then when you retire there is no major change in income. Just freedom.  No more alarm clocks, no more rush hour traffic, and no more scheduled breaks.

Let’s talk about the gorilla in the room. IRS.  The IRS always wants the monies due and they have laws to make sure they get them.  If you have a tax deferred account like a 401(k)/403(b) or an TIRA then they will eventually get their taxes.  There is a little nasty 3 letter acronym called RMD.  Required Minimum Distributions. This is how the IRS makes sure they get their money.  It starts at 70 ½ with a small percentage and then increases every year until it depletes the account.  It is designed to deplete the majority of the account by the time you in your mid to late 80’s. 

The Roth IRA has no minimum RMD and no taxes on withdrawals (after 59 1/2 and account open for 5 years).  If you have a large nest egg for retirement and don’t need a high withdrawal percentage and want the money to go to your heirs after you pass on, then the Roth IRA is far superior to the Traditional IRA.  With the Roth IRA you paid the taxes on the contributions each year as your contributions.  The longer you have the account and if the account earns a fair rate of return this can be a huge bonus for the retiree.  For example, let’s say twin brothers, 22yrs old, contribute the max $5500 per year for 8 yrs and then stops.  One contributes into a Traditional IRA and the other into a Roth IRA. They both let the accounts grow for 45 yrs until they are 67yrs old.  Also we will say they are both in the 15% tax bracket.  At the end of 45 years with an average 9% rate of return both accounts will have approximately $2,000,000.  But let’s look at the difference in the bottom line.

With the Traditional IRA the contributions were tax deductible and save the investor $825 in taxes ($5500 x 15%).  So for 8 yrs he saved a total of $6600, but all $2 million is taxable.  Once the RMDs kick in at some point the tax bracket would probably be more than the 15%.  Like I said there is no getting around the IRS getting their money.

With the Roth IRA you paid the taxes each year so you didn’t save the $825 in taxes.  But for this brother all $2 million is totally tax free.  That means he could take out 100k per year or take out all the money and pay no taxes.  And until he does take the money out the account is growing tax free with no RMD’s at 70 ½.  If he wanted to he could just leave the money in the account for his heirs to inherit.  He does not have to take any money out.

The biggest bonus to the Roth IRA is without the RMDs to liquidate the account in the later years most of your assets will still be in the account earning money instead of being distributed and used because it had to be removed for tax reasons. 

Roger - Your Money Coach




Living in United States