Q. Why would anyone ever invest in a traditional pre-tax IRA or 401(k) plan if all distributions are taxed at ordinary income rates rather than getting the gains at the lower capital gains rates? Example: I invest $5,000, and when I pull it out my account is worth $7,500. Id pay $3,000 when I pull it out rather than the $2,000 I would have paid in year 1 on $5,000 and $500 in year X on the $2,500 gain. Am I missing something?
A. No one knows for certain what their future tax rate will be due to the uncertainty of retirement income sources and potential changes to tax law. There is some rationale for investing in a traditional IRA or 401(k) versus investing in a regular taxable account. If you have the option of investing in a Roth IRA or Roth 401(k) and think you will be in the same or lower tax bracket in retirement; that is usually the better choice. Running some numbers may clarify why investing in a pre-tax vehicle still makes sense even though all money distributed is taxed at ordinary income tax rates versus the currently lower capital gains rate. Ill use your assumptions of a 40 percent income tax rate, a 20 percent capital gains rate and assume a 7 percent rate of return on investment in the examples.
Client A invests $5,000/year in a traditional tax-deductible IRA or pre-tax 401(k) plan for 20 years. At the end of the 20-year period, his account value is $204,977. If he withdrew the entire balance in one year (which is highly unlikely), 100 percent would be taxed at ordinary income-tax rates. Assuming his tax rate is still 40 percent ($81,991 owed in taxes), he would be left with approximately $122,986 after taxes.
Client B has the same $5,000 before tax to invest for 20 years. After he pays taxes, he has $3,000 to invest in a taxable account that is growth oriented and has little or no annual taxable distributions. At the end of the 20-year period, his account value is amazingly, $122,986! If he withdraws the entire balance in one year, he will owe capital gains tax on the growth of $62,986, which at 20 percent will reduce his account by $12,597. After taxes, he will have $110,388, which is $12,597 less than Client A.
Client C invests in a Roth IRA or Roth 401(k), and he has the same balance as Client As after-tax balance and Client Bs pre-tax balance $122,986.
In general, it is advisable to invest in a company plan (traditional pre-tax or Roth) to make sure you obtain any matching funds that are offered by your employer. After investing that amount for retirement, if allowed, contribute to a Roth IRA.
Up to $5,500 per individual (plus an additional $1,000 if age 50 or over) or earned income, whichever is less, can be contributed to a Roth IRA unless your adjusted gross income is too high. Eligibility to contribute to a Roth IRA for tax year 2014 is phased out over the following AGI levels: Filing status single, $114,000 to $129,000, married filing jointly $181,000 to $191,000 and married filing separately $0 to $10,000. Once your AGI is more than the upper limits above, no contribution is allowed.
Your personal situation may not correspond with general advice, and a meeting with a knowledgeable tax or financial adviser may be appropriate.
Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 97128, Raleigh, NC 27624