Thursday, August 21, 2008

To Roth or Not to Roth

If you have a choice between a tax-deductible retirement plan and a non tax-deductible retirement plan, which one should you pick?

The answer has a lot to do with a current unknown – future income tax rates.

Let’s leave aside the issue of increased future tax rates since we don’t know what they will be and can’t do anything about them if we did.

If you contribute to an IRA or 401k and deduct the contribution against your current income you are probably better off if you assume your marginal tax rate (the rate you pay on the last dollar of income each year) will be the same as it is now. This is due to the difference between your marginal tax rate and your effective (average) tax rate.

Here is the 2007 Tax Rate Schedule for married couples filing a joint return:

The income ranges shown in the “Over/But not over” columns are called brackets. Each bracket has its associated tax rate of 10% to 35%. If your taxable income lands you in the 28% bracket, then you pay 28% on each dollar of taxable income in excess of $128,500. By making a tax-deductible contribution to a retirement account, you reduce your taxable income and thus your income tax due by the same percentage.

Overall though, your income – including taxable retirement plan distributions - is taxed at your effective or average tax rate. Calculate this by dividing your tax for the year (Form 1040 line 63) by your taxable income for the year (Form 1040 line 43). The resulting percentage will be less than your marginal rate.

As long as your effective tax rate at the time of retirement account distributions is lower than the marginal rate at which the contributions were deducted, you are probably better off using a deductible retirement account if eligible. Since we don’t know now if this will be true, hedging one’s bets is advised.

You can hedge your future tax exposure by having a mix of “deduct now/pay later” (Traditional IRAs and 401ks) and “pay now/pay nothing later” (Roth IRAs and Roth 401ks) retirement accounts.

The income eligibility limitations for opening a Roth IRA are higher than they are for making tax-deductible contributions to a Traditional IRA. So it is possible that if you can’t deduct a Traditional IRA contribution you could be eligible to open a Roth IRA. If you don't qualify to make a tax -deductible IRA contribution, but are eligible to make a Roth IRA contribution do the Roth, as a Roth IRA is superior to a non-deductible IRA. (A non-deductible IRA contribution is not taxed upon withdrawal, but the earnings are taxed as ordinary income). There are no income limitations for participating in 401k plans although contributions may be limited for high income earners due to the non-discrimination rules if the plan doesn’t pass the required testing.

Remember that the rules can change: "Congress giveth, and Congress taketh away".


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