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How To Exempt Your Retirement Account From Taxes

It makes sense to pay more taxes now in order to exempt your IRA from future taxes.

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With the growing number of proposals to increase taxes, its time to rethink how we save for retirement. Proposals to increase the top income tax rate, impose a new annual estate/wealth tax, and to tax unrealized capital gains, are not likely to pass this year. However, the odds are rising that by the time you retire, taxes will be higher making a Roth IRA, where withdrawals are usually tax-free, significantly better for most people than a Traditional IRA. Here’s what you need to know.

The main differences

With a Traditional IRA, you don’t pay tax on the money you deposit, but the money you take out is taxed as ordinary income.

With a Roth, you deposit money on which you’ve already paid taxes, but the money you take out is not taxable.

Which one is better for you?

Let’s suppose that you are in the 30% tax bracket for 2018 and this weekend you have to decide whether to put $5,500 into a Roth or a Traditional IRA.

Click here to use Fidelity’s online calculator to find your actual maximum contribution.

If you put the $5,500 in a Traditional IRA, you will get an immediate benefit of $1,650 because you won’t have to pay taxes of 30% on the $5,500. Sounds good, but fast forward 20 years to when you start taking money out of the IRA. Your account will have grown tax-free for 20 years. At 10% a year, your account would be worth $33,637.

The catch is that the money you withdraw from a traditional IRA is taxed as ordinary income. If your income tax rate at that time is higher than it is now, you will pay that higher rate not just on the original $5,500 but also on all of the growth, even the portion due to capital gains which are usually taxed at a lower rate than ordinary income. If your tax rate at withdrawal time is 40%, you’ll pay $13,455 in taxes as you withdraw the money so you’ll have $20,182 to spend.

If you put the $5,500 in a Roth IRA, your tax bill will be $1,650 higher this year. But 20 years from now, you’ll be able to start withdrawing $33,637 without any additional taxes. Think of the $1,650 of extra taxes you pay this year as prepaying the taxes on a $5,500 investment.

Normally it’s not a good idea to pre-pay taxes. But in this case, the numbers argue otherwise. Instead of paying taxes of $13,455 as you withdraw the money from a traditional IRA, with a Roth you pay $1,650 now and then get 20 years of growth on $5,500 tax-free.

In other words, your $1,650 payment reduces your future taxes by $13,455. That in itself is a tax-free return of a little more than 11% a year on your $1,650 — a sweet deal!

If your taxes are lower in the future, or you have less than 20 years until retirement, the numbers will still favor the Roth, though by a smaller margin.

The return on your $5,500 investment over the 20 years is probably the biggest factor on the decision to fund a Roth or Traditional IRA. I assumed a 10% annual return in my example which approximates the long-run return of the S&P 500. If you invest 40% in bonds, your long-run return will likely be lower, but the Roth will still come out better.

As you work on your taxes this weekend, consider fully funding a Roth IRA.

Although there is a whiff of socialism in the air these days, the proposals to raise taxes are not likely to pass this year or next. But in the next 20 years, there will be 10 more elections.

In most scenarios, the Roth will work out to be better for your retirement even if tax rates don’t change. However, the more tax rates rise, the better the Roth looks.

This article is part of a series I write for those who want to get their portfolios back on track. To be notified when the next installment is published, click here.

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