December 31, 2012

Retirement Accounts: Traditional IRA v. Roth IRA

The federal tax code is structured to provide benefits to those who plan for their retirement, i.e. those who set up an individual retirement accounts ("IRA"). These benefits include tax-preferential treatment for these accounts. Two commonly used retirement accounts are traditional IRAs and Roth IRAs.

In a traditional IRA, the participant contributes pre-tax earnings to the account. This contribution is often considered to be tax-deductible. In other words, if Theo earned $50,000 in 2012 and contributed $5,000 to his traditional IRA, he could write off $5,000 for this as a tax deduction. Years later when Theo retires and withdraws a portion of his traditional IRA, this withdrawal is subject to ordinary income taxation. One of the benefits for using a traditional IRA is that a person can defer realization of income taxes to a future date when their income tax liability will be presumably smaller. The presumption is that a person will earn less money during their later years than during their middle ages. For example, Theo earns $50,000 in 2012 at the age of 40. Theo retires in 2027 at the age of 65 and begins to collect social security. Theo also begins to withdraw from his traditional IRA. The benefit for Theo is that his tax burden will be less at 65 than 40 because his earnings are far less because income taxes are progressive (the more you make the more you pay). Thus, Theo would presumably have more after-tax dollars by contributing to his traditional IRA at 40 and withdrawing his money incrementally at 65 than if he never made a traditional IRA contribution in the first place. 

One of the criticisms of traditional IRAs is that there is no guarantee that it will increase in value over time. Theo could make thousands of dollars of contributions earlier in his life but if his investments go awry he might have a smaller traditional IRA than he anticipated. Conversely, if Theo had a pension he would be arguably guaranteed a certain amount when he retired. For example, I have had a few clients who had modest pensions of $2,000 per month. On a personal level, my father received a $1,200 per month pension from Lockheed Martin.

In a Roth IRA, the participant contributes after-tax earnings to the account. This contribution is not a tax-deductible expense. For instance, if Theo earned $50,000 in 2012 and contributed $5,000 to his Roth IRA, he could not write off $5,000 for this as a tax deduction. One of the key distinctions between a traditional IRA and a Roth IRA is that the former is subject to income tax upon distribution whereas the latter is not. Assume Theo creates a Roth IRA and funds it with $15,000 over a periods of years. Theo's Roth IRA grows substantially in size as Theo makes a number of shrewd investments. When Theo begins to withdraw from his Roth IRA at retirement, these withdrawals are tax-free. In contrast, if Theo had created a traditional IRA, his withdrawals would be subject to income tax.  

There are a multitude of rules and regulations that govern IRAs. This post is by no means an exhaustive explanation of all the nuances involved. Rather the point is to highlight key distinctions between traditional and Roth IRAs, (1) tax liability upon creation and (2) tax liability upon withdrawal. Each has different results for (1) and (2).