Tax Features of IRAs
By Kaye A. Thomas
Current as of December 24, 2014
A look at the tax advantages — and disadvantages — of IRAs in general.
This page covers a few key facts about what makes an IRA tick. IRAs have been around for a long time, but some of these points are still often overlooked or misunderstood:
- Tax-free compounding. Everyone knows about this one because IRA promoters use it in their sales pitches. Is it oversold?
- Conversion of capital gains and dividends. This is the dirty little secret of IRAs: they convert capital gains into ordinary income and dividends. In some situations you can come out better using a regular taxable investment account than you do with an IRA.
- Rate shifting. Rate shifting occurs when you claim a deduction in a year when your tax bracket is high, and report the corresponding income in a later year when your tax bracket is low. Many people benefit from rate shifting if they contribute to a regular IRA or an employer plan and leave the money alone until retirement, when they’re in a lower tax bracket. If you’re in the 25% bracket or higher now and expect to be in the 15% bracket when you take money out of your IRA, you should think twice before choosing a Roth IRA, especially if you’re close to retirement.
- Deferral. Other things being equal, you’re better off if you can defer paying taxes until a later year, and have those dollars working for you in the meantime.
- Tax-free earnings. A feature that belongs exclusively to the Roth IRA is the ability to provide earnings that are entirely exempt from tax.
- Size of IRA. An important hidden feature of the Roth IRA: it’s larger than a traditional IRA.
In the discussion on this page, everything we say about a “traditional IRA” applies equally to any employer plan where the contribution reduces your taxable income, including a 401k or 403b plan. There are important differences between IRAs and employer plans, but they’re the same when it comes to the tax features described below. Similarly, the term “nondeductible IRA” includes not only a regular IRA for which deductions aren’t available, but also a Roth IRA if you expect to withdraw the earnings before age 59½ and pay tax on the distribution. When we refer to the tax features of a Roth IRA or designated Roth account (a Roth account in a 401k or similar plan), we’re assuming you’ll take only qualified (tax-free) distributions from the Roth IRA.
One of the key benefits of investing through an IRA or employer plan is tax-free compounding, a powerful but often oversold concept. We’ll look first at why it is so powerful, then look at why it’s not quite as powerful as it seems.
The benefit of tax-free compounding
Suppose you’re in the 25% tax bracket and project that your savings will produce income at the rate of 10% each year. You plan to save $2,000 each year. If you put these savings in a taxable account and pay taxes out of the earnings, the after-tax rate of growth is 7.5%. After 20 years you’ll have about $93,000 ($40,000 of savings plus $47,000 of earnings).
Now let’s see what happens with tax-free compounding. To isolate this effect, we’ll assume you put the same $2,000 per year into a regular, nondeductible IRA. That way, you still don’t get any deduction when the money goes in, and you still pay tax on the earnings — but you pay the tax at the end, when you take the money out. The money compounds at the pre-tax rate of 10%, and accumulates to $126,000. After you pay 25% tax on the earnings, you’re left with $104,500 — about $11,500 more than if you had the money in a taxable account. (Of course if this were a Roth IRA you would get to keep the entire $126,000.)
This example shows that tax-free compounding can produce a significant benefit even if you get no deduction when the money goes into your IRA and have to pay tax when the money comes out. The benefit can increase dramatically if you extend the time period, increase the earnings rate, or increase the tax rate (perhaps adding in the effect of state income tax).
Why it’s oversold
Tax-free compounding is great, but it’s worth knowing that the benefit of tax-free compounding is also available to some extent in a taxable account if you invest for capital gains. People who buy stocks and hold them for long periods can build value over many years without paying tax on the gains until the shares are sold. Even if you do some trading, with careful planning you can use capital losses to reduce or eliminate capital gains. The calculation in the example above assumes that in the taxable account you’ll pay tax on all your investment profits each year, and that’s not what’s really going on. Tax-free compounding is a significant benefit of IRAs, but not quite as big as some of the sales literature makes it appear.
All IRAs provide the benefit of tax-free compounding, but the potential benefit is greatest in the Roth IRA. There are two reasons: the Roth IRA is effectively bigger (as explained below), and tax-free compounding can continue longer in a Roth IRA because the minimum distribution rules don’t apply. The opportunity to maximize tax-free compounding is one of the reasons to favor the Roth IRA — but you won’t harvest that benefit unless you take advantage of it by maximizing your contributions and minimizing your distributions.
Conversion of capital gains
Here’s a point that’s overlooked by a surprising number of people who own IRAs: earnings you withdraw from an IRA are taxable as ordinary income. This is true even if the IRA’s earnings came from long-term capital gains or dividends that would otherwise be taxed at the special, lower rates. The IRA converts those capital gains and qualified dividends into ordinary income — and causes them to be taxed at a higher rate.
With an investment strategy that emphasizes long-term capital gains, it’s sometimes possible to do better in a taxable savings account than a nondeductible IRA from which you make taxable distributions. Of course this doesn’t apply to a Roth IRA if you qualify to take the earnings out tax-free.
Rate shifting is a potentially valuable feature of traditional IRAs and employer plans such as 401k plans. The idea is to claim a deduction in a year when your tax rate is high, then receive a corresponding amount of income in a later year when your tax rate is lower. Rate shifting is most important for people who are in the 25% bracket or higher while they are working, but will be in the 15% tax bracket when they retire.
Example: For ten years you contribute $2,000 per year to a deductible IRA or 401k while you’re in the 25% bracket, getting deductions that save you a total of $5,000. You withdraw these amounts (together with earnings) after retirement when you’re in the 15% bracket. You pay only $3,000 tax on the return of your $20,000 of contributions, and get to keep the additional $2,000 in tax savings.
The benefit is considerably less dramatic if the rate shift is from the 28% bracket to the 25% bracket. And there’s no guarantee that rate shifting will work in your favor. You may be in the same tax bracket after you retire, and it’s even possible you’ll be in a higher bracket then (due to a large inheritance, for example, or a change in the tax law). But for many people, rate shifting is one of the keys to maximizing the accumulation of wealth for retirement.
A more limited form of rate shifting is available with a regular, nondeductible IRA. There’s no deduction for contributions, but the earnings are being taxed in a later year, so you can get some favorable rate shifting on the earnings. In a Roth IRA you get no rate shifting on contributions — but the best rate shift possible on the earnings: a shift to no tax at all.
Deductible contributions to an IRA or 401k throw another factor into the equation. They provide tax deferral, something that’s valuable even in the absence of rate shifting. When you contribute to a deductible IRA (or a 401k), you reduce the amount of income tax you pay in the year of the contribution. You also increase the amount of tax you pay when you take that money out. But in the meantime, you have the use of the amount you would otherwise have paid in taxes. It’s like getting an interest-free loan.
Roth IRAs don’t provide deferral. Instead they provide the opportunity to receive earnings tax-free, which can be just as good or better. Nondeductible IRAs also don’t provide deferral, and they don’t provide the ability to receive earnings tax-free, either. In most cases this means a deductible IRA is better than a nondeductible (non-Roth) IRA.
The Roth IRA adds a unique tax feature to the equation: the ability to withdraw earnings entirely free from tax. Of course you need to meet certain tests to obtain this benefit. See Tax-Free Roth IRA Distributions.
Here’s an interesting point: all other things being equal, the benefit of receiving tax-free earnings is the same as the benefit of deferral. If you eliminate rate shifting, and permit exactly the same amount of tax-free compounding, you end up with exactly the same number of dollars in your pocket at the end of the day:
- Regular IRA: You receive a deduction when you contribute $3,000 to a regular IRA. You’re in the 28% tax bracket, so your tax savings equal $840. In other words, it cost $2,160 for you to make this contribution. The $3,000 grows at a 10% rate and at the end of five years you withdraw the entire balance: $4,832. You pay 28% tax, and you’re left with $3,479.
- Roth IRA: You put $2,160 into a Roth IRA. You get no deduction, so the cost of this contribution is the same as the cost of the $3,000 contribution to a regular IRA. The $2,160 grows at a 10% rate and at the end of five years you withdraw $3,479. You pay no tax on the withdrawal, so you end up with exactly the same amount as if you had used a regular IRA.
This does not mean the Roth IRA is always, or even usually, equivalent to the regular IRA. On the contrary, most people are better off in the Roth IRA. One of the big reasons is explained in the next section.
Size of the retirement account
There’s one more feature of Roth retirement accounts that’s somewhat hidden: they’re effectively bigger than traditional accounts holding the same dollar amount. The reason is that all the dollars in a Roth IRA are after-tax dollars. The dollars in a deductible IRA are pre-tax dollars. And even in a nondeductible (non-Roth) IRA, the earnings are pre-tax dollars.
If you want proof, take a look at the example in the previous section. We showed that if all other things are equal, a contribution of $2,160 to a Roth IRA produces the same result as a contribution of $3,000 to a regular IRA for someone in the 28% tax bracket. But of course you’re permitted to contribute up to the same dollar limit in a Roth account as in a traditional account. When you maximize your contributions to a Roth account, you’re making a larger contribution than you can make in a deductible IRA. Over the long run this hidden increase in the size of your IRA savings can greatly enhance your accumulation of wealth for retirement.
For more on this topic, see Roth Accounts Are Bigger.