By Sheryl Rowling
Q: My accountant told me that I could contribute to a Traditional IRA or a Roth IRA. How do I choose?
A: Assuming that you’re planning to hold the IRA for a while, it really depends on your current and expected tax brackets. First, let’s go over how each IRA works. With a Traditional IRA, you get to deduct your contribution, and earnings are not taxed while the money’s in the account. However, when you withdraw funds at retirement, you pay tax on all your withdrawals. With a Roth IRA, you don’t get to deduct your contribution. However, earnings are not taxed and your ultimate retirement withdrawals aren’t taxed either. Bottom line – you never pay tax on Roth IRA earnings!
If you’re in a high tax bracket, you should probably contribute to a Traditional IRA. For example, Howard is in the 33% tax bracket. He contributes $5,000 to a Traditional IRA and saves $1,667 in taxes. At retirement15 years later, after earning 8% per year, the IRA is worth $15,833. Assuming that Howard’s retirement tax bracket is 15%, his after-tax IRA value is $13,458. Had Howard invested $3,333 ($5,000 minus the $1,667 tax savings) in a Roth IRA earning 8% per year, he would have had only $10,666 after fifteen years.
If your current tax bracket is low, you might opt for a Roth IRA. For example, Phyllis is in the 15% tax bracket. She contributes $5,000 to a Traditional IRA and saves $750 in taxes. At retirement fifteen years later, after earning 8% per year, the IRA is worth $15,833. Assuming that Phyllis’s retirement tax bracket is 33%, her after-tax IRA value is $10,608. Had Phyllis invested $4,250 ($5,000 minus the $750 tax savings) in a Roth IRA earning 8% per year, she would have had $13,500 after 15 years.
Q: Can an IRA be advantageous for my teenaged kids?
A: Actually, yes. If you have your own business and hire your minor child (for legitimate work), you can deduct the pay and your child can use the money for a Roth IRA. For example, let’s say that Steve hires his 15-year old son Sam. He pays Sam $5,000, who, in turn, contributes the money to a Roth IRA. Steve gets a tax deduction that reduces his income tax and self-employment tax. Sam pays no tax because he has not earned over the minimum threshold. Assuming an 8% annual return, Sam’s $5,000 Roth IRA will grow to over $230,000 by the time he retires at age 65.
Q: My wife and I are retired. In addition to investment accounts, my wife and I each have an IRA. We want to leave some money to our kids, but we also want to leave a legacy to our temple and the Jewish Community Foundation. Do you have any ideas?
A: Yes. Why not leave your IRAs to charity? Although all of your assets figure into estate tax, only certain assets remain subject to income tax upon inheritance. This “income in respect of a decedent” includes retirement accounts, Traditional IRAs, savings bond interest and annuity income. On the other hand, inherited appreciated stocks or real estate receive a “stepped-up” basis to fair market value – meaning that your heirs can avoid income tax on appreciation.
Let’s say that you have a house worth $500,000 (with a cost of $200,000), investments of $500,000 (with a cost of $300,000), and Traditional IRAs worth $500,000. If you wish to leave $500,000 charity and $1 million to your children, you should designate the IRA for charity. If you give the investments to charity, your children will inherit the house and the IRAs. Your children won’t pay tax on an immediate sale of the house (because of the basis step-up), but they’ll pay tax on the entire IRA balance. So, if they are in the 30% tax bracket, they’ll end up with only $850,000 ($500,000 from the house and $350,000 net from the IRAs). If you leave the IRAs to charity, your children will inherit the house and the investments – with no income tax consequences. Thus, they will receive the full $1 million while your charities will still receive $500,000.
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Rowling is a certified public accountant, personal finance specialist, and principal of Rowling & Associates. She may be contacted at sheryl.rowling@sdjewishworld.com