I am reading up on IRAs and the available information is overwhelming. I think I would get it then read something else and get confused again. The thing I don’t understand is how my IRA contributions will affect my taxes. I don’t understand the difference between tax-deductible and tax-deferred. Are they the same thing?
Suppose I make $80,000 a year and contribute 15% to a 401k. I understand that the 15% subtracted from my taxable income. I’ll get taxed on $68,000 instead. That’s easy enough.
So now say I reduce my 401k contributions and contribute $5,000 to a traditional IRA instead.
I read how if my income is below $56,000 for this year (and I still participate in a 401k), the $5,000 is “fully deductible.” If I make between $56,000 and $66,000, it’s “partially deductible.” Anything above $66,000 is not deductible. So does that mean I will have to pay taxes on the $5,000 (as I can’t deduct it from my taxable income)? What is the benefit then of the IRA for people making over $66,000? Just the tax savings on the interest? Is that the tax-deferral?
I think almost everybody who couldn’t deduct their traditional IRA contribution would instead put money in a Roth IRA, which doesn’t provide a current tax deduction, but lets you not pay taxes on the earnings when you withdraw them if you follow the rules.
There are probably some cases where it might make sense to invest in a traditional IRA even if you couldn’t deduct it, but it’s probably uncommon. Sheltering money from a bankruptcy or divorce settlement, maybe?
ETA: to answer your question more directly: Tax deductible means you can deduct it from your income. Tax deferred means that you don’t pay tax on it now, but you will have to pay tax on it later. They’re related, but not exactly the same thing. For example, certain types of medical expenses are tax deductible, but not deferred. You don’t ever have to pay taxes on them.
A Traditional IRA or 401k and most other retirement accounts are (usually) “immediately” tax deductible. You lower your income by the amount you put in, either on your paycheck or come next tax time. But when you take money out of the account after you retire, you have to pay tax on your deduction.
A Roth IRA or Roth 401k is deferred. If you make $30,000 and put $5,000 in a Roth, you pay taxes on $30k income for that tax year (ignoring other deductions/credits). But when you retire, you do not pay tax on any of that that you took out because it’s already taxed.
The basic decision comes down to: do I expect to be taxed at a higher rate when I retire than I am now? Also other reasons why someone might choose one over the other, like if their income is too high to get an immediate deduction.
The general order of things that get forbidden due to income: Trad IRA with deduction, Roth IRA, then Trad IRA with no deduction.
Some people can’t get 401k/403b/457s through work. So they have to put into an IRA. Others maxed out their 401k and want to save more.
You are using “deferred” incorrectly. Roth accounts are not tax deferred. Traditional IRA/401(k) are, in that you are deferring the tax payments to later.
Roth accounts are simply investment accounts that allow tax-free withdrawals upon maturity.
While marginal tax rates are a consideration, I think far too much emphasis is put there. It is not the most important factor.
One of the major missed items in tax planning for retirement is how taxable vs. nontaxable income affects the tax you pay during retirement. By setting up the amounts you take from each category, you can avoid paying tax - even on the taxable income.
Let’s say you have a couple who plans to need $5k a month ($60k a year) for retirement. They get $20k of this from Social Security and $40k has to come from a combination of other assets.
If all $40k comes from a tax-deferred plan like a 401k, then they pay a fair bit of tax on this. The first problem is that the amount of taxable income makes a portion of Social Security taxable (let’s say $50k is now gross income, total). They can subtract their standard deduction and personal exemptions for about $30k in income subject to tax, and pay about $4k in tax.
On the other hand, if $20k comes from the 401k and $20k comes from a nontaxable source (a Roth account or even a standard savings account), then you get tax savings in two ways. First, the Social Security is nontaxable, since your taxable income is so low. Second, your deduction and exemptions reduce taxable income to $0.
So you see that proper planning can manufacture a lower tax bracket.