By: Clay Wyatt
Roth IRA taxes are different than those on traditional IRAs. Instead of deferring taxation until a IRA distributions occur, as is the case with a traditional IRA, Roth IRA taxes are paid up front. In other words, the income is taxed in the current year instead of when you retire. In most cases, this leads to taxes only being paid on the principal, not the interest, as Roth IRA taxes are only withheld on the upfront investment, not the distribution.
As mentioned, Roth IRA taxes are paid up front. However, such contributions are not deductible from your income unlike a traditional IRA plan, which allows for both tax deferral and the deduction of your contributions. This takes on the greatest importance if you are near an tax bracket threshold that would allow you to benefit from tax deductions that are currently not available to you. Simply adding more money to an IRA could reduce your taxable income and save you tax money through both tax deferral and by moving you into a lower income bracket. However, paying Roth IRA taxes will not afford you this benefit.
The differences between Roth IRA taxes and IRA taxes become greater as your income bracket rises. Your overall tax liability will likely be higher when paying Roth IRA taxes if you are in a moderate to high tax bracket. This is due to the fact that many people are in a higher tax bracket during their working years than during their retirement years. Thus, with a traditional IRA, you have the opportunity to both lower your tax bracket now, which will reduce your current taxes, and defer taxation on your investments to the future, when your taxes will likely be lower.
Another difference lies in your state of residence. Most US states currently impose an income tax (nine states have no income tax and a few others do not tax withdrawals from IRAs or tax only a portion). If you currently live in a state that has an income tax and defer taxation on your investments until after you retire, you will have the mentioned benefits of tax deferral. You may also avoid taxation at the state level altogether if you retire to a state that does not have an income tax if you participate in a traditional IRA. However, you will not be eligible for any of these benefits if you participate in a Roth IRA because Roth IRA taxes are withheld after the contribution, not the withdrawal. On the other side of things, if you currently live in a state that has no income tax and move to a state that has an income tax after you retire, you will avoid state taxes that you would otherwise have to pay by investing in a Roth IRA.
The future of taxation also must be taken into consideration when comparing Roth IRA taxes to traditional IRA taxes. The national debt is at an all time high of nearly $14.5 trillion and growing by the second. Total unfunded US liabilities are over $114 trillion and growing. We can see that the potential for higher taxation in the future is significant, which would favor Roth IRA plans versus traditional IRA plans, as paying Roth IRA taxes upfront would be better than paying traditional IRA taxes during periods of heavier taxation.
Which type of IRA account will work best for you? That depends on where you live, where you plan to retire, and how much faith you have that Uncle Sam will not raise taxes through the roof in the future. It also depends on your tax bracket and a variety of other factors. Check with a tax consultant or retirement advisor before deciding whether you'd pay less Roth IRA taxes or traditional IRA taxes. Doing so will help you determine what the best route is for your retirement savings.
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