I consider myself to have above-average sophistication for an investor. Yet there is one thing I never thought of before.

When you contribute to an IRA, the part of your income used for the contribution is not taxed; it’s deferred until you withdraw it. Then that money is invested and there is no tax on the growth, also deferred until withdrawal.

Now when you retire and start to withdraw it, your withdrawals are taxed as ordinary income. However, that means that not only your contributions are taxed, which seems reasonable, but your capital gains are taxed at the ordinary income rate, rather than the capital gains rate.

I haven’t run the numbers yet, but is the benefit of deferring taxes on the contributions really enough to outweigh the additional tax you will pay on the realized gains?

So you come out ahead in the traditional IRA some smallish amount over the 22% beginning level (I’m on my cell phone so can’t do the math now). Maybe someone else can tell us if this is wrong.

Not sure I’m following you. You didn’t pay it when contributing but you have to pay it when you withdraw. The theory is that you’ll be in a lower tax bracket when you retire, but that is not universally true.

Sure, and that’s why retirement investments can be complicated for some people.

For most people, contributing to an IRA is just going to be a good idea. But that of course is not universally true. If you expect your tax rate to be higher in retirement than now, maybe it’s better not to contribute so much. It depends on what you expect will happen, and nobody can tell the future with absolute certainty. Financial planners exist for this reason. They can step you through the ins and outs and potential issues.

On that note, if you expect your income in retirement is really going to be that high (at least based on current tax rates and reasonable projections of such into the future), congratulations!

However until you hit required minimum distribution age, you don’t have to withdraw anything. When I was in my late 60s I controlled my withdrawals to stay in a lower bracket. That went all to hell when I started taking full Social Security at 70.
I figure if you are making enough income so that this is a problem, you don’t need to withdraw until it becomes mandatory, which is I suppose why the RMD law is there.

I once figured this out. I am in Canada, but the rules are much the same. The fact that your income on the investments are not taxed immediately but reinvested overwhelms the difference between paying capital gains taxes yearly and ordinary income taxes many years later.

The other advantage to the IRA investment is that you need to compare the pre-tax dollars invested in the IRA vs the post-tax dollars invested in a post-tax account. In other words, you can put $100 in the IRA or ($100 - your marginal tax rate) in a post-tax investment. Especially if you do this when you are young, that can make a big difference down the road.

No, all other things being equal, it doesn’t make any difference. Wether you are taxed in the way in or the way out, the result is the same. Look at an example of someone with a 20% tax rate who gets a 5% return for 40 years:

Traditional: $5000 invested for 40 years with 5% return: $35,200 - after tax, $28160
Roth: $4000 invested for 40 years with 5% return: $28160

What matters is if your tax rates during the contribution and withdrawal phases are significantly different. If you believe you will have a lower tax rate when withdrawing than when contributing, Traditional makes sense. Otherwise, Roth wins.

This is not a meaningful concern. There is not a vehicle where you can invest pre-income-tax money at contribution time, and then pay capital-gains rates at withdrawal time. If you’re paying capital-gains rates, the money in the account must be post-income-tax.

The two main options for what you can do with post-income-tax money are Roth IRA/401K (no tax on withdrawal) or non-qualified investing (capital gains taxes when realizing). Of those, the Roth is the obvious winner on taxes.

In the bigger picture, projections of income tax rates now vs. later factor into the Traditional vs. Roth decision.

We can make it much more complicated than that, though. Because the maximum investment for traditional and Roth is the same we need to even things up.

Let’s go with the same numbers, the old $5000 max contribution, 20% tax rate, and 5% (compounded monthly) return over 40 years. To invest equal amounts in each type of IRA we have:
$6250 = $5000 Roth + $1250 taxes^{[1]}
$6250 = $5000 traditional^{[2]} + $1000 savings + $250 taxes^{[3]}

The Roth is a simple calculation. Full cash out of the Roth on our initial $6250 taxes+investment is $36792.

For the traditional IRA we start with the $5000 investment and get a final balance of $36792, we lose 20% of the earned interest to taxes, so in our pocket we have $30433 including interest and initial investment. We’ve invested the $1000 in savings at the same 5%, but we’ve paid 20% taxes on the interest every year, so end up with a total of $4976.

Full return on our traditional investment of $6250 is $35409.

(Returns on the traditional are even worse if you blow the $1000 on losing scratch off tickets.)

Is that right? What am I missing?

income tax we paid on the money before putting it in the Roth ↩︎

But this is true if you invest outside of a retirement account, as long as you don’t take realized gains. For example, invest in an S&P 500 index fund.

For most fund investments, you’ll have realized taxable gains along the way, eating away at your return. So, year one, you earn 8%, but only 6% after taxes to get reinvested, etc. Those gains along the way get taxed at a lower capital gains rate, of course, but it’s a drag every year.

In an IRA, all taxes are deferred and the full amount can be reinvested each year.

This is a good counterpoint to the “IRAs and Roths equal out”, but it can be misleading. For many, their preferred/most convenient investment vehicle is their 401k, and may not be close to maxing out their yearly contribution limit. So for them, their projections don’t include a non-qualified account.

Also, taxing 20% on the non-qualified each year is a bit of a cop-out. Have them invest in Berkshire Hathaway for the duration and get a one-time cap gains hit at the end. With no dividends, Berk.B is a good no-hassle proxy with zero turnover.