Is a traditional or roth IRA preferable at my income level?
Before taxes, I make k a year, which is not much of an income. I've been told that people who have low incomes should get a Roth IRA since they won't make much money off of tax deductions, so I got a Roth IRA at my local bank and deposit a little money into it every month.
I pay around ,800 a year in taxes. If invested in a traditional IRA, could I get all or most of the money I pay in taxes back to re-invest? Would you recommend someone who makes k a year getting a traditional or Roth IRA?
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Assume you make 16k/yr for 45 yrs of your working life. You put k in an IRA each year with a 7% interest rate. You can also make 7% interest outside your IRA. Let's assume you live an extra 20 years after retirement and withdraw everything in your IRA to use for the remaining 20 years of your life. In this case, your IRA would contain roughly 1.22 million $ when you retire. Of this 180k is principle and 1.04 million is interest.
Scenario 1: You choose a Roth IRA, and pay 0/year in taxes while working. But in retirement, you pay zero tax. In this case, you paid a total of 18k in taxes.
Scenario 2: You invested in a regular IRA. Here you saved 18k in taxes over the 45 years of working due to deductions. And if you were continually reinvesting this income, at 7% interest rate (and but deducting the 15% tax the gov takes on interest income), you would turn the tax savings into 89k.
So which is better scenario 1 or scenario 2? Well, if you divided the 1.04 million interest income in your IRA by 20 (years of withdrawals), you get 52k in interest income / yr. Now subtract the standard deduction and you have 40k per year of taxable income. So you'd pay around 5k per year in taxes on that income. That is about 100k saved in taxes over the 20 years.
IRA: money saved 89k (investing saved taxes)
Roth IRA: money saved 100k (taxes you don't have to pay when you retire)
Roth wins in the above scenario. There are a ton of assumptions in this calculation to make the math easier, and I'm guessing you could construct scenarios where the regular IRA wins. One assumption is that interest making stops once you start retirement, another is that you only live 20 yrs past retirement. The 7% interest rate is also uncertain. I assumed the Roth IRA would be favored by a ton, but when doing the math it appears that both retirement options save you similar amounts of money.
One reason to choose the Roth is that tax rates are currently at historic lows. If they were to raise in the future, your interest income would be exempt from these raises, because you pay no taxes on interest income in a roth.
As I understand it.
Your aim is to maximise your effective after-tax return. The US government gives you two choices for your tax-advantaged retirement accounts, you can pay tax up-front "roth" or pay tax when you take the money out "traditional".
If your effective tax rate is the same at contribution time as withdrawl time then it doesn't matter which you go for. Your after-tax return is the same (in the traditional case you pay more tax, but you also make more money from your investments).
So the big question you need to ask yourself is what do you expect to happen to your income over time? Unless you never plan to retire or you have other significant passive sources of income you want to have at least some money in a traditional IRA/401K to use up your tax allowances in retirement. On the other hand if you expect to earn significantly more money in the future than now then it makes sense to put the money in a roth to take advantage of your current realtively low tax rate and contribute to the traditional IRA/401K later when your marginal tax rate is higher.
The main difference between a traditional and Roth IRA (assuming equal contributions) is the timing of taxes. You want to avoid taxes when the rates will be highest, so since your income is low now and presumably will be higher in the future, you would probably be better off investing in a Roth, paying the tax now, and avoiding tax in the future.
Yes, it would be nice to have a little bit more of a refund, but you'd be saving about 10% in tax now in exchange for possibly paying around 25% in tax in the future.
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