IRAs and retirement taxes

[MattM]

I have a question regarding Roth vs. traditional IRA's. When I read that the Roth is superior, the reasoning is that your contributions and earnings are tax free in retirement of course, but what is left out of the discussion about 100% of the time is that the same initial investment into a traditional IRA triggers a significant tax deduction that frees up additional funds that can also be invested back into the IRA. The nest result is that the correct answer to the question "which one is better", is that if your tax bracket is higher now than it will be in retirement, traditional is better, but if you expect your tax bracket to be higher in retirement, Roth is better. If your tax bracket will be the same, it's a wash.

What I do not know is how various forms of income are treated to arrive at your predicted future tax bracket...i.e. someone with $75,000 of earned income would be in a 25% tax bracket at present, and would pay a certain amount back in income tax (maybe $5,000 for instance...I'm just guessing because the actual number is not important to the concept). How would those taxes be calculated for a retired person with $25K from Social Security, $25K from a qualified IRA, and $25K from a nonqualified IRA = $75K?

I do know that the brackets will change but for this example I am ignoring that variable.

[TBman]

Originally Posted by MattM

I have a question regarding Roth vs. traditional IRA's. When I read that the Roth is superior, the reasoning is that your contributions and earnings are tax free in retirement of course, but what is left out of the discussion about 100% of the time is that the same initial investment into a traditional IRA triggers a significant tax deduction that frees up additional funds that can also be invested back into the IRA. The nest result is that the correct answer to the question "which one is better", is that if your tax bracket is higher now than it will be in retirement, traditional is better, but if you expect your tax bracket to be higher in retirement, Roth is better. If your tax bracket will be the same, it's a wash.

What I do not know is how various forms of income are treated to arrive at your predicted future tax bracket...i.e. someone with $75,000 of earned income would be in a 25% tax bracket at present, and would pay a certain amount back in income tax (maybe $5,000 for instance...I'm just guessing because the actual number is not important to the concept). How would those taxes be calculated for a retired person with $25K from Social Security, $25K from a qualified IRA, and $25K from a nonqualified IRA = $75K?

I do know that the brackets will change but for this example I am ignoring that variable.

Post deleted

[The Growler]

And don't forget some states have their confusion to add, such as some not taxing Social Security.

You have to guesstimate it for you, keeping in mind that you have no real way to determine what tax rates will be in the future, except likely they will be higher. Sometime we'll have to start paying for all the borrowing.

[Bucc5207]

What's a qualified vs non-qualified IRA?

Basically, you estimate taxes by pretending to prepare a return assuming the various predicted sources of income and deductions. You do a fake Form 8606 to calculate taxability of IRA income (when the taxpayer made some non-deductible contributions in the past), you do the Social Security worksheet to calculate how much SSI is taxable, etc.

Planning for retirement taxes more than a few years ahead requires a good crystal ball and great faith in government. There is always a strong possibility that the rules will change before one retires. That is the big downside to Roth IRAs: you have to rely on the government keeping its promise never to tax Roth distributions.

[The Growler]

Originally Posted by Bucc5207

Planning for retirement taxes more than a few years ahead requires a good crystal ball and great faith in government. There is always a strong possibility that the rules will change before one retires. That is the big downside to Roth IRAs: you have to rely on the government keeping its promise never to tax Roth distributions.

There you have it. What will be taxed and how much is a guess. Many planners go with the "conventional wisdom" that you'll be in a lower tax bracket upon retirement, but that's not a given.

[Bucc5207]

Originally Posted by The Growler

There you have it. What will be taxed and how much is a guess. Many planners go with the "conventional wisdom" that you'll be in a lower tax bracket upon retirement, but that's not a given.

Agreed. Lower tax bracket in retirement is by no means a given. For one thing, tax brackets these days are very broad (e.g., the 2014 25% bracket for married couples extended from $73,801 to $148,850), so most people need a huge reduction in income to drop into a lower bracket.

For people whose current income greatly exceeds the cost of their lifestyle, 'lower bracket' might be a fair assumption. Most people, however, do not adopt a less expensive lifestyle upon retirement. So, if you spend most of your income now, you will probably need a similar income in retirement to support your spending habits. That means your tax bill in retirement will probably not change much, either.

Once you retire, you stop paying into Social Security and Medicare, and perhaps you have paid off your mortgage, so you may derive more discretionary funds from less taxable income. But really big reductions in income tax on retirement will probably happen only for very high earners with modest lifestyles.

[buddyhu]

Originally Posted by The Growler

There you have it. What will be taxed and how much is a guess. Many planners go with the "conventional wisdom" that you'll be in a lower tax bracket upon retirement, but that's not a given.

You make it sound so precarious. I don't think it is. Income tax rates have changed during my life time, but tax increases tend to be smaller, and more gradual. It is the tax cuts that tend to be more sizable and dramatic. At least in my life time. If taxes are levied on Roth IRAs (a BIG IF, even though folks fuss and wring their hands about such things often), it will be a small tax, on the order of sales tax percentages. Yes, that is enough for most folks to feel it, but it won't, in most cases, eliminate the benefit of a Roth over a long time span.

For those who really mistrust the government, you should be less aggressive in your attempts to maximize tax saving through a Roth, and put some in a Roth, some in a non-Roth retirement account, and keep some outside of any retirement account.

[Bucc5207]

Originally Posted by buddyhu

You make it sound so precarious. I don't think it is. Income tax rates have changed during my life time, but tax increases tend to be smaller, and more gradual. It is the tax cuts that tend to be more sizable and dramatic. At least in my life time. If taxes are levied on Roth IRAs (a BIG IF, even though folks fuss and wring their hands about such things often), it will be a small tax, on the order of sales tax percentages. Yes, that is enough for most folks to feel it, but it won't, in most cases, eliminate the benefit of a Roth over a long time span.

For those who really mistrust the government, you should be less aggressive in your attempts to maximize tax saving through a Roth, and put some in a Roth, some in a non-Roth retirement account, and keep some outside of any retirement account.

As the investment guys like to say, "Past performance may not be indicative of future results."

[The Growler]

Originally Posted by buddyhu

You make it sound so precarious. I don't think it is. Income tax rates have changed during my life time, but tax increases tend to be smaller, and more gradual. It is the tax cuts that tend to be more sizable and dramatic. At least in my life time. If taxes are levied on Roth IRAs (a BIG IF, even though folks fuss and wring their hands about such things often), it will be a small tax, on the order of sales tax percentages. Yes, that is enough for most folks to feel it, but it won't, in most cases, eliminate the benefit of a Roth over a long time span.

For those who really mistrust the government, you should be less aggressive in your attempts to maximize tax saving through a Roth, and put some in a Roth, some in a non-Roth retirement account, and keep some outside of any retirement account.

So we agree. Your tax rates aren't going down.

[MattM]

Originally Posted by Bucc5207

What's a qualified vs non-qualified IRA?

Basically, you estimate taxes by pretending to prepare a return assuming the various predicted sources of income and deductions. You do a fake Form 8606 to calculate taxability of IRA income (when the taxpayer made some non-deductible contributions in the past), you do the Social Security worksheet to calculate how much SSI is taxable, etc.

Planning for retirement taxes more than a few years ahead requires a good crystal ball and great faith in government. There is always a strong possibility that the rules will change before one retires. That is the big downside to Roth IRAs: you have to rely on the government keeping its promise never to tax Roth distributions.

I am sorry I was not very clear on that...qualified are IRAs that have special tax benefits, so I don't think I was using the term correctly. I meant 25K from a Roth IRA and 25k from a tax deferred (i.e. traditional) IRA.

[SongwriterFan]

Originally Posted by Bucc5207

As the investment guys like to say, "Past performance may not be indicative of future results."

And yet they all use it for their predictions.

I can't figure out why nobody wants to follow MY investment advice: since we know that all funds must eventually just match S&P (nobody can continue to outperform it every year), then we should only invest in funds that have historically Underperformed the S&P . . . . because eventually they must outperform the S&P to get back to the norm.

[MattM]

So far the most informative reply was a PM where I was told that the IRS taxes 85% of your SS benefits. In this example, for a single filer, 85% of SS plus the traditional IRA withdrawals would be $46,250 taxable, and the break for single filers is $37,400, so in my example, a single filer would be saving a full 25% on all Roth distributions.

If her were married, he would only be saving 15% on the distributions, as the break is almost $75,000 for married filing jointly. It would not be a good swap to pay 25% taxes on contributions now to save 15% on distributions later.

[harmonics101]

Originally Posted by SongwriterFan

And yet they all use it for their predictions.

I can't figure out why nobody wants to follow MY investment advice: since we know that all funds must eventually just match S&P (nobody can continue to outperform it every year), then we should only invest in funds that have historically Underperformed the S&P . . . . because eventually they must outperform the S&P to get back to the norm.

OH My Goodness - Now THERE'S some contrarian thinking

H

[SongwriterFan]

Originally Posted by harmonics101

OH My Goodness - Now THERE'S some contrarian thinking

Are YOU ready to follow my awesome investment strategy? You'll be my FIRST (and only) customer.

[Bucc5207]

Originally Posted by MattM

I am sorry I was not very clear on that...qualified are IRAs that have special tax benefits, so I don't think I was using the term correctly. I meant 25K from a Roth IRA and 25k from a tax deferred (i.e. traditional) IRA.

Thanks for clarifying.

There is no easy one-size-fits-all shortcut answer. The best thing to do (other than seeking professional help) is get some forms and instructions from IRS.gov, and work through it as if you were doing a tax return. That's the surest way to avoid missing any unexpected wrinkles and getting an accurate answer.

In the simplest terms, if all the conditions are met, the Roth distribution should not be taxed at all, and the traditional IRA distribution is 100% taxable as ordinary income (same as wages). Social Security may be partially taxable; the SS worksheet in the Form 1040 instruction book will help you figure that out. If there are any other sources of income (interest, dividends, capital gains, part-time employment, etc), you need to include all of them or the SS worksheet will not give the right result.

If you ever made nondeductible contributions to the traditional IRA, it might not be 100% taxable. In that case, you need to know how much of it was already taxed (your 'basis'), and you need to know the market value of all traditional IRAs combined. You feed that info through Form 8606 to find how much of the traditional IRA is taxable.

All of that gets you as far as Adjusted Gross Income (bottom line on Page 1 of Form 1040). Then you flip to Page 2 and work through deductions and exemptions and credits and possibly 'other taxes' to arrive finally at your estimate of total tax.

If you are not totally drained of energy yet, you now proceed to your state forms and do the same exercise (usually easier - the heavy lifting is on the federal side).

Good luck!