Traditional IRA and Roth IRAs

Traditional and Roth IRA’s aren’t typically considered retirement plans for small businesses, but they can be a savings vehicle for small business owners in lieu of a formalized plan.  Annual limits on investments in Traditional and Roth IRA’s are $6,000 in 2021, or $7,000 for persons 50 or older.  

Don’t be embarrassed to ask what the difference is between a Traditional IRA and a Roth IRA.  Many people have the same question.  The difference lies in the timing of when or if taxes are paid on your investment and its earnings.  To help you understand the advantages of investing through Traditional or Roth IRAs, let’s first take a look at how investments are taxed when they are funded outside of either type of plan.  

 

EQUITY AND DEBT INVESTMENTS MADE OUTSIDE OF A RETIREMENT PLAN

When money is invested outside of an IRA or other retirement account, taxes are paid on the invested funds in the year the funds are earned.  Since the original funds invested have already been taxed, they become the tax basis for the investment.  (More on basis in a minute.)  Each year additional taxes are paid on earnings attributed to the investment, such as dividends and interest.  If those earnings are reinvested, rather than distributed to the investor, they increase the basis in the investment because they represent additional funds that have already been taxed.  (If the dividends or interest are distributed to the investor, rather than reinvested, there is no change in the basis.)

When the investment is sold, capital gains taxes are paid on any gain or loss recognized on the investment.  (Capital gains have a more favorable tax rate if held for more than 12 months.)  This is where the importance of basis comes in, because the gain or loss on the investment is the difference between the selling price and the basis of the investment. So where does an increase come from if you’ve already paid taxes on the original investment and all the earnings?  It’s the increase or decrease in the market value of the investment between the date it was purchased and the date it was sold.

Now, with that information in hand, let’s look at how Traditional IRAs and Roth IRAs differ.

 

TRADITIONAL IRA

The primary benefit of investing through a Traditional IRA is the deferral of taxes.  Amounts contributed to a Traditional IRA are deductible in the year the contribution is made, so you defer paying the taxes until you take the money from the IRA.  You also defer paying taxes on the earnings from the investment until you withdraw them.  However, when you finally do retire and take the money out of your IRA, you pay tax on both the initial investment amount plus the earnings, including the change in the market value of the instrument, and you pay it all at regular tax rates.  (You don’t get the more favorable capital gains tax rate.)

EXAMPLE:  Say you invest $1000 into a Traditional IRA when you are 40.  Now assume that by the time you reach retirement age, your $1,000 investment has grown to $5,000.  ($1,000 initial investment, plus $4,000 in earnings.)    

In the year that you invest the $1,000, your taxable income decreases by $1,000, so you pay less tax.  If your marginal tax rate was 15% in the year you make the investment, your taxes would decrease by $150.

When you reach retirement age, you want to supplement your social security with your IRA savings, so you take $2,000 out of your account.  Your taxable income will increase by $2,000, so if the tax rate were once again 15%, you would owe an additional $300 in taxes in the year of withdrawal.

Although you don’t receive a favorable capital gains tax rate when you withdraw from your traditional IRA, the theory is that retirees typically are in lower tax brackets in retirement than they are in the years in which they are employed.

 

ROTH IRA

Contributions to a Roth IRA don’t alter your taxable income in the year that you make the initial investment.  You still pay tax on the money you invest into the Roth.  The big advantage that Roth IRAs have over Traditional IRAs is that you never pay tax on the gains to your investment if you hold your investment for 5 years and past the age of 59 1/2.  

EXAMPLE: The same set of circumstances as above except you invest $1,000 in a Roth IRA when you are 40.  Your income in the year you make the investment is unaffected, so compared to the example above, you pay $150 more in taxes in the year you make the investment; however, when you reach retirement age and draw $2,000 out of your Roth account, you don’t pay taxes on any of the withdrawal.  You pay $300 less than in the example above.  And t

There is another benefit to investing in Roth IRAs that should be considered:  the difference in a withdrawal’s effect on the taxation of your social security benefits.

A portion of your Social Security benefits are taxable in 2021 when 50% of your benefits plus all your other taxable income exceeds $25,000 for single persons or married filing separately, or $32,000 for married couples filing jointly.  Withdrawals from a Traditional IRA account increase taxable income and could, therefore, increase the amount of social security benefits that are subject to income taxes; but withdrawals from a Roth IRA have no effect on taxable income, and will not contribute to the amount of your social security benefits that are subject to income tax.