IRAs: Weighing the Merits
Traditional IRAs and Roth IRAs both give you the advantage of tax-deferred growth potential. What's different is what happens when you take money out of your account after you reach age 59½.
With a traditional account, what you withdraw is considered regular income, and you owe income tax on the earnings at your current rate. If you've deducted your contributions, you owe tax on that part of your withdrawal as well. As a result, the amount you have available to spend is reduced by whatever you owe in tax. That's why many experts suggest that you may want to put growth investments in a regular, taxable account. The capital gains tax rate when you sell them is always less than your tax rate on ordinary income. For example, if your marginal rate is 25% to 35%, your capital gains rate is usually 15%. If your marginal rate is 10% or 15%, the capital gains tax rate is 0%.
However, higher rates do apply for people with higher incomes. If you file your federal income tax return as a single and have an adjusted gross income (AGI) of $434,550 or higher in 2019, you pay a capital gains tax rate of 20%. If you are married and file a joint return, the 20% rate applies if your AGI is $488,850 or higher.
In addition, if you file as a single and have an AGI of $200,000 or higher, you pay an additional surtax of 3.8% on investment income, including capital gains. If you're married and file a joint return, the 3.8% surtax applies if you have an AGI of $250,000 or higher. In other words, there are actually three possible capital gains rates: 15%, 18.8%, or 23.8%.
Withdrawals from a Roth account are completely tax free if your account has been open at least five years and you're older than 59½. That's a big difference that gets bigger as your tax rate goes higher. For example, if you withdrew $40,000 in one year, you would have about $10,000 more in your pocket if the money came out of a tax-free account than if you paid income tax on it at the 24% rate.
Roth IRAs offer other advantages, too, if you're eligible to open one, based on your income. Unlike a traditional IRA, you can continue to contribute for as long as you have earned income - even if you're 90.
Perhaps more important, you're not required to begin withdrawals at age 70½ as you are with a traditional IRA. That means you can manage your finances to suit yourself, or use your account to build the estate you'll leave your heirs. There may be tax consequences with that approach, though, so you should discuss your plans with your tax or legal adviser.
THE PENALTY QUESTION
To get the tax breaks that come with an IRA, you accept the condition that you won't have free access to the money until you turn 59½. It's the government's way of encouraging you to save for retirement.
But you do have some flexibility. If you need money you've put into an IRA to pay certain medical expenses, buy a first home for yourself or a family member, or pay your children's college tuition, you can withdraw from your account without owing the 10% tax penalty that usually applies to early withdrawals.
If the money is coming out of a traditional IRA, you'll owe whatever tax is due, just as you would if you withdrew after age 59½. But you'll have the rest to spend on those important expenses. With a Roth IRA, you'll owe tax at your regular rates for earnings in the account you withdraw to pay college expenses. But you can take up to $10,000 tax-free if you're buying a first home for yourself or a member of your family. And if you need money you can withdraw your contributions without owing tax.
There's general agreement that flexibility is good. But is withdrawing early a smart move? Those who say it's not point out that you run the risk of not having enough to live comfortably in retirement—at a time when it's harder to borrow or to work extra hours for added income. In addition, since compounding is an important component of maximum growth, you won't have the potential to accumulate as much if you start rebuilding an account at age 40 or 50 as you would if your money had been left undisturbed.
IRAs cost little or nothing to set up and aren't expensive to maintain. Financial Institutions may charge between $5 and $50 to open your account and often a similar annual fee, although sometimes they'll waive the charges to attract or keep your business, especially if you have a sizeable balance.
Since usually the fees are fixed rather than based on the size of your IRA, they have a much smaller impact than the management fees often imposed on other retirement savings plans. And you can subtract the annual fee as a miscellaneous deduction on your income tax return if you pay the fee by check rather than having it deducted from your account.
But the annual fees don't cover annual management and other fees on the separate accounts themselves. Those costs can't be paid separately. They are typically based either on the total value of your IRA, depending on the type of fee, and are not tax deductible.
WHEN IS AN IRA NOT AN IRA?