With one week left in the 2014 tax season, many are trying to think of ways to reduce the tax bill for next year. One way to plan for taxes, both now and later, relates to our choice of tax deferred retirement planning vehicles. Making the correct choice can yield a larger after tax income in retirement. However, making the choice can be complicated by our inability to know what future tax rates may be or what level of income we’ll have in retirement.
The choice resides between two philosophies. The traditional plans, like IRAs and 401Ks allow the participant to make contributions to the plan and receive a tax deduction for the portion of their earned income they contribute each year. There may be limitations on deductibility of traditional IRA contributions, depending on level of income and simultaneous participation in an employer sponsored retirement plan.
These traditional plans are of the pay later variety, meaning that you enjoy the up-front tax deduction for contributing, tax deferred growth of the assets in the plan during your accumulation phase, but distributions from the plan during your retirement phase are taxed as ordinary income.
The pay now plans are the Roth variety of IRAs and 401Ks. With these plans, there is no tax deduction for making annual contributions, so you are taxed on the income as you earn it, even though it ends up in a retirement vehicle. But the assets in the plan continue to grow tax-free during your accumulation phase, and there is no tax on distributions from the plan in your retirement phase. And, unlike traditional plans, you are never ever required to take required minimum distributions from a Roth plan, even when you reach age 70 1/2. You can leave the entire Roth to your heirs, if it turns out you don’t need to use the account for income.
However, your ability to contribute to a Roth IRA may be lost if your income is too high. In 2015, contributions begin to be limited for adjusted gross income greater than $183,000 for a married couple ($116,000 for individuals), and is completely lost at $193,000 for joint filers ($131,000 for individuals). These limits are adjusted for inflation every year or so.
So how do you make the choice of which type of plan to which to contribute? As stated earlier, there is not an exact formula that can be applied with certainty because we can’t be sure what the income tax rates will be 10, 20 or 30 years from now. We also don’t know for sure what our level of income will be after retirement, which determines our after retirement tax bracket.
But, we can make some judgment calls. With the nation’s debt burden, I think it is a fair assessment that tax rates have a better chance to be the same or higher down the road than to be lower. In this scenario, the Roth plans would have an advantage because the cost of the taxes now may be lower than the cost in the future. In addition, since distributions from Roth plans never find their way to your tax return in retirement years, the income derived from your Roth won’t have an impact on the possible taxation of your Social Security Income.
The traditional plans, which offer the immediate tax break, should be your choice if you don’t believe tax rates will be significantly higher in the future, or if your level of retirement income will be modest enough to keep you out of the higher tax brackets.
There are calculators which can help with this decision, allowing you to provide data on your personal situation and make assumptions on current and future tax rates. To find them, you can do a search for the terms “Roth vs. Traditional IRA calculator.”
Tom Breiter is president of Breiter Capital Management, Inc., an Anna Maria based investment advisor. He can be reached at 778-1900. Some of the investment concepts highlighted in this column may carry the risk of loss of principal, and investors should determine appropriateness for their personal situation before investing. Visit www.breitercapital.com.