I am not sure what the advantage of tax deferral is here:
Lets say I can contribute $20,000 and get 5% (for easy math) and check my earnings after 5 years.
IRA: 20,000 * 1.05 * 1.05 * 1.05 * 1.05 * 1.05 = 25,525
Withdraw 25,525 at age 60 and pay tax (est 25%) = 19,144 in my pocket
on the other hand if I take the 20,000 and pay the 25% tax up front as normal income, I am left with 15,000. And after 5 years: 15,000 * 1.05 * 1.05 * 1.05 * 1.05 * 1.05 = 19,144. Same result except in the IRA case I have no access to the funds.
Is there only a benefit if the tax rate goes down by the time I want to withdraw? This seems like an unlikely gamble.
Note there is no employer match here because I own the company… obviously if I was working for someone else the employer match would be free money.
First, with a good IRA plan you are likely to earn a better rate of return than 5% – which you can do easily enough in a savings account. Second, the investments you make in an IRA (typically stocks and mutual funds) would under normal circumstances be taxed at the capital gains rate – when withdrawn after retirement from a traditional IRA, they are taxed as regular income.
Finally, you did not account for the income tax you would pay on the interest you earn – this is not taxed while in the IRA.
Long-term capital gains taxes are currently at 15%. The capital gains in your IRA will be taxed when you withdraw the funds as regular income, the rate for which is determined by your income bracket when you retire. Assuming you’re not making a lot of income at the time, that could be as low as 10% or lower with credits.
You will be paying tax on the gains/interest on the subsequent years where your $15000 is earning 5% in an unsheltered account. You don’t pay tax on gains in the IRA, which is tax sheltered. You just pay tax on withdrawals as income.
friedo’s post crossed mine. Another point is that the tax rate may well go down for you, personally, if you are drawing substantially less income in retirement than you were earning while working, and are in a lower tax bracket.
Ah, true on the interest being taxed outside of an IRA.
I guess my question really comes down to this:
I own property overseas (Czech Republic) where I have a mortgage. In the last two years the rate has dropped from 1USD = 25.5 CZK to today at 1USD = 17.5 CZK. This is a 30% loss in USD purchasing power in 2 years. I expect it will continue to fall though maybe not at the same rate.
I have the option to contribute $20K to an IRA, or I can take it as cash and pay 33%, then get the remaining 13,400 into Gold/Euros/CZK.
You might also want to look at the Roth IRA. You fund that with after-tax dollars, do not pay tax on the interest, and do not pay tax on the withdrawals.
I’d appreciate a reference to this $20,000 contribution limit. The last time I checked (which was a while ago), the annual contribution to any form of IRA was $4,000 ($5k for the 50 and older demographic). What’s changed in the tax laws?
As others have noted, the major flaw in your example is that in your non-IRA savings account, you also pay taxes on the earnings each year. Thus, in the first year, your $20,000 earns 5% = $1,000 but you pay tax on that, so you only have $750. Thus, you’re really only keeping 3.75% each year, not 5%; hence 15,000 * 1.0375 * 1.0375 * 1.0375 * 1.0375 * 1.0375 = $18,031. The difference is fairly small, because you’re only talking about five years. If you leave your money in an IRA for ten or twenty years, there’s considerable tax savings.
And, of course, if the earnings rate is more than 5% in some of the years, the difference will grow accordingly.
If you’re self-employed, you can open an SEP IRA, which has somewhat different rules. This IRS page details the SEP regulations. Although for some reason I was also thinking the upper contribution limit was $20,000, they say the limit for 2007 is the lesser of 25% of compensation or $45,000.
Right. And $20K is roughly the amount I am allowed since it gets into weird rules when one is overseas and excluding income from federal tax under other IRS rules.