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How are tax rates for Roth and Traditional IRAs determined?

Personal Finance & Money Asked by motley on December 28, 2020

I know Roths are all the rage since they were introduced, but I’m not necessarily seeing how or why they are the way to go. As most of you probably know (but FYI for those who don’t), the difference is that with a Roth IRA, you’re taxed on that money now and won’t get taxed when you draw money from it in retirement; with a Traditional IRA, it’s the opposite.

My question is: at what rates? How is that determined? If I’m taxed now on a Roth, is that rate based on my TOTAL income (i.e. not just the Roth money but my current salary/etc)? Similarly, with a Traditional, am I taxed only on the money I pull out (assuming that is my only "income" other than whatever money my retirement portfolio makes)? Assuming all of that is true, it seems more likely to me that the Traditional is better as I am very most likely to be pulling/making less money from my IRA in retirement than the money I’m making now, as is the likely case for most I’d think. So where’s the Roth appeal?

3 Answers

You aren't taxed on the Roth contribution itself. You are taxed normally on the money you earned whether you do the Roth or not. The difference is that with a traditional IRA you can subtract your contribution from your annual income when calculating your taxes.

When the money is distributed it works in the opposite direction. Withdrawing from a Roth doesn't incur any taxes as long as you are after retirement age. With a traditional IRA you are taxed on withdrawals pretty much exactly the same as if you had earned it from a job.

For the most part it pretty much equals out in the end unless (a) tax rates go up in retirement; or (b) your income (including the IRA withdrawal) is way less in retirement so you are in a lower tax bracket than your working years.

If the tax rates stay the same and you withdraw an annual amount equal to what your paycheck was from your job, you will have the same tax bracket as before.

One trick is to contribute to both, so when you withdraw you take a little from each. That way you can take less out each year from the IRA and reduce your tax rate, but supplement it with tax-free Roth money.

Also, you don't know what your financial situation will be in retirement so hedging your bets by mixing up your retirement savings may give you more options later.

Answered by JohnFx on December 28, 2020

Focusing on the portion where you ask:

Assuming all of that is true, it seems more likely to me that the Traditional is better as I am very most likely to be pulling/making less money from my IRA in retirement than the money I'm making now, as is the likely case for most I'd think. So where's the Roth appeal?

The most obvious case where a Roth is much better than the traditional IRA is for the young during their high school and college years. When my children had their first jobs they didn't make enough money to get above the standard deduction. In that case they contributed to a Roth IRA. They paid taxes their contribution (0%) and now will be able to withdraw tax free the contributions and the gains when they retire. As their income increases the Roth appeal may/will diminish and they may move to a split and then entirely traditional.

Answered by mhoran_psprep on December 28, 2020

Looking at my retired income, small pension, income from rental, and SS they add up to close to my peak earning income. Also, I used to have dependent care and paid interest on my mortgage that I could deduct so my taxable income was reduced in ways it isn’t today. I made deductible IRA and 401K contributions, but in hindsight I wish I had done a 50/50 split.

Answered by Don on December 28, 2020

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