Every year, the Congress of the United States of America gets an updated report on IRAs.
Why does Congress they get these annual updates on the history and law surrounding IRAs? Well, they get them because IRAs were created by the government to encourage people to save for retirement.
This savings vehicle, the IRA, has only been an option for the last 47 years.
At first, the only IRA was the Traditional IRA. But, when the government creates something, it generally morphs over time. The Roth IRA was introduced to the American people in 1997.
If we do the math, this timing makes pretty good sense. Anyone who got an IRA in 1974 was probably reaching the age to take distributions in the early 1990s. When they did, they were being hit with taxes they never expected. Ed Slott says that even tax accountants had not prepared their clients for the taxes found in a Traditional IRA.
People were shocked.
The good citizens of the United States who had invested in an IRA were suddenly paying a much larger portion of their retirement savings to the government than they ever expected, and the government’s IRA solution didn’t look as appealing anymore. It stands to reason that the Roth IRA was born in response to this tax-shock.
So, what did the government do with the Roth that they hadn't done with the Traditional?
Taxes and Distributions
Many people already know that the Traditional IRA lets you make pre-tax contributions but with the Roth IRA, contributions are after-tax.
What does that mean exactly?
Let’s look at what pre-tax means first. For the sake of simplicity, let’s talk about a guy named Ryan.
Ryan is single, under 50, has an income of $85,000, and he’s not covered by a retirement plan at work. This puts Ryan in a position to take the full deduction available if he puts money into an IRA. For 2021, that deduction/contribution limit is $6,000.
Ryan can put $6,000 into an IRA and have that deducted from his income. If he was 50 or older, he’d get to contribute an extra $1,000 (called a catch-up) making his total allowed contribution $7,000.
Quick note here: if you choose to contribute to a Roth IRA and a Traditional IRA in the same year, your limit for all IRA contributions is still a total of $6,000. Contribute any more than that, and you get a lovely “excess contribution tax” of up to 6% if you don’t withdraw that excess by tax day.
Anyway, back to Ryan.
He decides to open a traditional IRA and contributes 6,000 in 2021. When he files his taxes in April of 2022, his AGI or Adjusted Gross Income has gone from $85,000 to $79,000.
When his AGI was $85,000 he was in the 24% tax bracket. Now that the IRA contribution has brought his income down to $79,000 he is in the 22% tax bracket.
See how that works?
Ryan has gone from a $20,400 tax burden (minus his deductions) to a $17,380 tax burden. Ryan walks away with money in a retirement account and a few thousand dollars in savings on his tax bill for the current year.
But, that money is tax-deferred or tax-postponed. What that means is, Ryan didn’t have to pay income tax on $6,000 for the year. Removing that amount from his income put him in a lower tax bracket and that helped him have a lower tax bill overall for 2021. However, when he takes that money out of his retirement account, it will be taxed to the full extent of the law at whatever tax-rate our government deems necessary.
Here’s the take-away:
Pre-tax contributions can be helpful if you’re right on the verge of a lower tax bracket and/or you really want to lower your taxes a little for the current year.
When deciding on which IRA works for you, you’ll have to be realistic and consider whether you’re actually going to be in a better place to pay taxes on that money in retirement.
You also have to consider whether you’ll have enough money to pay the income taxes that are deferred for retirement.
Trust me, I know that there is a lot that goes into this decision and that’s why talking to a professional can really help you strategize here. If you’re not sure how to figure some of this out, please give my office a call and we can schedule a chat about your situation. We actually, truly, enjoy crunching these numbers.
Now, for the Roth IRA, I’ll introduce you to Steven.
He's single, under 50, and has an income of $100,000.
Contributing to a Traditional IRA would not put him in a lower tax bracket and he’s more concerned with his tax bills in the future. Steven knows that he’ll save money later if he lets his money grow in a Roth account. He contributes $6,000 to a Roth IRA in 2021 and still pays income tax on that $6,000 with his yearly taxes.
When Steven wants to take out that original contribution, there will be no tax for him on that day. This brings me to the differences between these IRAs that show up when it’s time to withdraw your money.
For traditional IRAs, “Withdrawals…are subject to income tax in the year that they are received.” So, the year you take out the money to use it is the year you pay income tax on that money for a traditional IRA. “Early distributions are withdrawals made before the age of 59½. Early distributions may be subject to an additional 10% penalty.” These quotes are taken straight from the report to congress.
So, with a traditional IRA, you can’t take money out until you are 59.5 or there’s a penalty.
Also, traditional “IRA holders must begin making withdrawals by April 1 of the year after reaching the age of 72.” There is actually a penalty for waiting to withdraw your money past the age of 72.
For a traditional IRA, not only is there a tax penalty for not taking your money out by a certain age, there is also a penalty for not taking out enough of the money in any given year past 72. That penalty can be up to 50% of what you were supposed to withdraw and that’s huge.
Because the Traditional IRA is set up so that government let you have a tax break on the year you contributed that money, they make certain that the tax break is not indefinite. And that is why you’ll have to take some of that money out and pay taxes on it by the time you’re 72.
The government decides how much you have to withdraw. This is called the required minimum distribution or RMD. There are currently proposals waiting to be voted on that could move the age for the RMD back, and will be watching this closely.
The calculation on what that minimum distribution has to be can get confusing because it’s found in IRS publications and changes each year. When it comes time to disburse your money from a traditional IRA, you’ll have to make sure you really understand the calculations or work with a professional so that you don’t end up with a penalty.
I know I’m really driving this home, but I do not want to see anyone with a 50% penalty. It can be devastating.
One last note before we move on from Traditional IRAs, since 2007, the government has allowed distributions after you’re 70.5 to be made to qualified charities and not count toward your taxable income.
Now, on to Roth IRAs distributions:
In order to even be eligible to open a Roth IRA, you have to fall within certain income limits. However, a Roth will protect your money from future taxes, if you qualify.
Once you put your money into the Roth, it has already been taxed, so it won’t be taxed when you take it out. As I said before, there’s no penalty for withdrawing any amount up to your full contribution amount in a Roth at any time.
The earnings on your contributions in a Roth IRA can be withdrawn without a tax penalty if:
“They are made after the five-year period beginning with the first taxable year for which a Roth IRA contribution was made, and
They are made on or after the age of 59½; because of disability; to a beneficiary or estate after death; or to purchase, build, or rebuild a first home up to a $10,000 lifetime limit.”
So, if you’re withdrawing under those circumstances, you’re going to move forward tax-free. If you contributed money to your Roth IRA and it earned $100,000 by the time you’re 60, as long as you put it in over 5 years ago, that money is considered yours and you don’t have to pay any taxes on it.
There are also “non-qualified” distributions with a Roth IRA. These get a 10% penalty and they are taxed. If you withdraw your earnings before you’re 59.5 and/or before the 5 years is up for that contribution, you could end up with a tax bill as well as a 10% tax penalty. You have to make your withdraw decisions carefully if you decide to use your Roth IRA money prior to turning 60.
Clearly, the decision about which investment would be better is completely dependent on your specific situation. If you have questions or would like help looking over your options, feel free to give my office a call or shoot us an email. We’re here to help and we’d be happy to set up a free consultation with anyone struggling to figure this stuff out.