Have you ever heard of the expression, “Would you rather pay taxes on your seeds or your crops?” Let’s put it another way, would you rather pay taxes at the beginning of your retirement plan investment or the end of a twenty-to-forty-year investment cycle?
My name is Rebekah Littleton, MAcc a Senior Staff Accountant at Killingsworth Spencer CPAs. In this article, I want to point out the key differences between a Roth IRA account and a traditional IRA, or 401(k) retirement plan.
In a Roth plan, there is no tax savings with your contribution; however, gains within the account are not subject to any taxation upon withdrawal after 5 years and age 59 ½. An IRA or a 401(k) saves federal & state income taxes at the time of contribution. Traditional IRA and 401(k) withdrawals are subject to ordinary income taxes, both fed & state at the time of withdrawal after age 59 ½. All retirement plans are subject to an early withdrawal penalty of 10% before age 59 ½. Thus, the primary difference between Roth and traditional retirement plans is how contributions are taxed, at the beginning, with no tax on earnings, or at the time of withdrawal.
The maximum contribution allowed for Roth and traditional IRAs is the same in 2023 – $6,500/yr. to age 49, and $7,500/yr. if you are 50+ yrs. old. If your Modified Adjusted Gross Income (MAGI) exceeds $153,000 as a single taxpayer or $228,000 as married filing joint, you are not allowed to contribute to a Roth. 401(k) contribution limits are vastly different, $22,500 up to age 49, and $30,000 if you are 50+ yrs. old. There are no MAGI limits for a 401(k) contribution.
-Taxes on Seeds or Crops –
To keep the math simple, when you contribute to either an IRA or a 401(k) of $6,500 you can deduct about $1,300 if your federal effective tax bracket is 20%. However, as discussed above, the Roth contribution offers no upfront tax savings. Using the Rule of 72, the account will double in value every 9 years with an 8% rate of return (72/8 = 9). Going out 36 years, you will get four doubles. Your initial $6,500 investment should be worth approximately $104,000. In the Roth account, withdrawals will be tax-free (after 5 years and age 59 ½). The IRA or the 401(k) will be taxed at the current effective ordinary income tax bracket. For example, if you take a $10,000 withdrawal, you will pay about $2,000 in federal taxes plus whatever the state income tax rate is that year.
-The better alternative, if available-
Some employers have adopted the 401(k) Roth IRA combination retirement plan which has been around for over twenty years. This type of plan is not common because it is more expensive for the employer to implement and maintain. The contribution maximum is still $22,500 up to age 49, and $30,000 if you are 50 or older.
Here is the best part! There is no MAGI income limit, and you can put the entire contribution into a Roth account if you wish. The caveat is that any employer matching funds to a Roth account must be placed into a future ordinary income taxable account at retirement.
So, to answer the question, “Is a Roth IRA better than a traditional IRA or 401(k)?” You are better off sitting down with your CPA and your financial advisor to determine your goals and retirement needs in a carefully laid out plan. Every person’s situation is different, and what may work best for one individual or family might not work for others. Give Killingsworth Spencer CPAs a call at 770-552-8286 to set up a consultation for tax planning or return preparation.