Many individual retirement accounts (IRAs) give an investor the opportunity to lower her current tax bill while setting up an income stream for her retirement. A Roth IRA, however, is the best way to minimize the tax she will pay if her income at retirement is greater than it is today.
Even so, the Tax Policy Center reports that in 2017, 35 million owned a traditional IRA and 25 million owned a Roth IRA and that, at the end of 2016, traditional IRA balances totaled $6.9 trillion and Roth IRA balances totaled $700 billion. These numbers suggest that many taxpayers don’t recognize the many benefits of the Roth IRA. For instance, retirement nest eggs held in Roth IRA accounts are FDIC insured.
Later-In-Life Tax Savings
If luck is with you, the $1,000 present-day tax savings you may earn by maxing out your traditional IRA contribution may generate a return over several decades that’s much greater than the tax savings that a Roth IRA makes possible. But it’s uncertain what future returns the $1,000 tax savings will actually earn.
For the taxpayer who is likely to pay tax at a lower rate today than at retirement, the FDIC-insured Roth IRA is worthy of consideration. For instance, the dollar impact of the ability of a Roth IRA to lower the future tax bills of trust fund babies and those working in roles earning top salaries for a lifetime, such as data scientists, may be much greater than the benefit of investing that $1,000 tax savings.
Current Tax Rate Lock-In
The choice between a traditional IRA and a Roth IRA is a simple one: contribute to a traditional IRA and pay taxes on your retirement savings later in life, or pay your taxes now and save for retirement with a Roth IRA.
By making a Roth contribution, you will get your tax break when you retire, rather than in the year of your cash contribution. Once you retire, your withdrawals from your Roth IRA account have no effect on your taxable adjusted gross income (AGI). Based on the rate at which your contributions were compounded over the years, that tax break might be significant.
If you’re at the beginning of your career or have other sources of income, each of which assures you that you’ll be in a higher tax bracket when you retire than you are today, a Roth IRA is well worth your consideration.
Traditional IRA vs. Roth IRA
Assume that in 2021 you’re 27 years old and earn $42,000 a year. Based on your current tax bracket of 22 percent, your federal income tax bill is about $9,240. If you contribute $6,000 to a traditional IRA, you lower your adjusted gross income to $36,000, which will save you about $1,320 in federal taxes at year-end.
But what if you pay the additional $1,320 and contribute the $6,000 to a Roth IRA instead? If you earn an average 6.8 percent return for 40 years on that sum – the average return in the years 1971 to 2020, as reported by MoneyChimp – by age 65, the $6,000 has grown to about $93,385, which you can then withdraw tax-free.
While this is a simple example that doesn’t account for many factors that influence the financial benefit of any investment, it does illustrate how a Roth IRA can affect the tax you’ll owe once you’ve retired.
Read More: Roth vs. Traditional IRA for Young Investors
FDIC-Insured Roth IRA Accounts
The Federal Deposit Insurance Corporation, or FDIC, is a government-run agency that protects account holders against deposit losses if a bank or savings and loan association fails. Roth IRA assets held on deposit are insured according to FDIC insurance limits: $250,000 per depositor, per institution and per ownership category, which gives investors confidence that their primary risk lies with the investment vehicles they choose for their Roth IRA accounts.
For insurance purposes, the FDIC combines all your IRAs in one category. If one banking customer has a $200,000 certificate of deposit held in a traditional IRA and a $100,000 Roth IRA held in a savings account at the same financial institution, the agency will collectively insure both investments for $250,000. The $50,000, which exceeds the $250,000, will not be insured.
Billie Nordmeyer is an IT consultant of 25 years standing. As a senior technical consultant for SAP America and Deloitte Touche DRT Systems, a business analyst, senior staff, and independent consultant, Billie has worked across the retail, oil and gas, pharmaceutical, aeronautics and banking industries. Billie holds a BSBA accounting, MBA finance, MA international management as well as the Business Analyst and Software Project Management certificates from the Cockrell School of Engineering at the University of Texas at Austin.