Talk:Traditional IRA

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[edit] Traditional IRA Taxed "Effectively" after "Deductions"

There is some incorrect or misleading information in the article regarding how traditional IRAs are taxed at retirement when there are withdrawals. For example, the article says, "Because qualified distributions are taxed as ordinary income (the taxpayer's highest rate)" In most cases, the withdrawal in a given year would NOT be entirely taxed at the taxpayer's highest rate. It may, in fact, be taxed overall at a much lower rate. I will explain below.

The article also states "When the money is withdrawn from the Traditional IRA it will be taxed at marginal rates. ", In most cases, this is not true. The withdrawals are taxed as ordinary income on a year by year basis as they are withdrawn from the total growth of the account, typically after 59 1/2 years of age. I'll explain below why the tax paid would normally be much less than the marginal tax rate.

Every comparison I've seen of Roth IRAs vs. traditional IRAs makes the assumption that when someone withdraws from a traditional IRA that they will be paying the marginal tax rate on the entire withdrawal without factoring in deductions, exemptions, or the lower tax brackets that are paid into before even reaching the marginal tax rate. It's not just a matter of whether the "marginal" tax rate is higher at retirement than while contributing, as is often stated as the primary determining factor. It's the "effective" tax rate that really matters. When factoring these other elements into the calculations to get the "effective" tax rate, the traditional IRA is often the much better investment. This is why I stated that the article is INCORRECT OR MISLEADING to state that someone in the 30% tax bracket upon retirement receiving $1000 in traditional IRA distributions would incur $300 in taxes. Usually it would be much less than the "marginal" tax bracket.

For example, if a typical single middle class income earner is making $40,000/yr and can afford to contribute 6% of his income to a traditional IRA, he would be able to contribute only $2400/yr, which is less than the maximum allowed. If he chose a Roth IRA, after taxes, only $1800/yr would actually go into the Roth IRA due to the balance going to taxes. Assuming identical investment growth percentage, the Roth IRA growth would amount to a total which is 25% less than the traditional IRA growth. The first year of retirement, a withdrawal of $40,000 from a traditional IRA would be taxed as ordinary income. Using 2007 tax tables, the standard deduction $5350 would apply, the personal exemption of $3400 would then be subtracted, the remaining would have tax applied in the 10% and 15% tax brackets, and only the remaining taxable income in excess of $31,850 would be taxed at 25%. Factoring in the deduction, exemption, and 3 relevant tax brackets, the effective tax is 10.74% on this withdrawal. (I used this calculator to calculate the average/effective tax - http://www.dinkytown.net/java/TaxMargin.html) In this typical middle class example, this is a better option than the Roth IRA where the growth is already 25% less than the standard IRA growth. The traditional IRA would allow him to withdraw for more years due to the higher growth amount and lower "effective" tax rate. I could have used a married couple and an $80,0000/yr figure in this example showing the same "effective" tax rate of 10.74% using a traditional IRA, and making it the better choice over the Roth IRA. Financial advisers often advise going with Roth IRAs based on the marginal tax rates expected to be higher at retirement versus the contribution years, but that totally misses the reality of deductions and the tax rate structure used to calculate taxes when making withdrawals during retirement, which results in a much lower "effective" tax rate than "marginal" tax rate at retirement for the middle class. As the article is today, it is not accurate in showing the advantages/disadvantages of a Roth vs a traditional IRA.69.44.28.121 (talk) 06:49, 23 March 2008 (UTC)Harley