The Benefits of a Traditional IRA

How Traditional IRAs Work

Traditional IRAs in their present form have been around since 1975, when they were referred to as regular IRAs, earning the name traditional due to their tenure and also to distinguish them from a later incarnation of retirement accounts called Roth IRAs, which are distinctly different.

The Benefits of a Traditional IRAThe main feature of a traditional IRA is its allowing contributors to defer paying income tax on designated amounts until withdrawn. This can present several advantages, and the overall net effect will depend to a large degree on the rate of taxation at the time of contribution versus what is actually paid when taken out, with the main idea being allowed to pay tax on contributed amounts in retirement where our income usually drops and our tax rate may as well.

It is not necessary to expect this to benefit from contributing to a traditional IRA, as there can be significant benefits that can accrue even if the same rate of tax is paid or even if it is taxed at a higher rate than would have been paid otherwise, if the funds are held in the IRA for a long period of time.

This would all be made simpler if not for the existence of the Roth IRA, and given that we can choose between them to allot our annual IRA contribution limit overall, generally speaking, we need to have the income taxed at a lower rate than would have been paid if not for the IRA to make sense of this strategy versus putting the money in a Roth IRA.

Many people struggle with deciding which to take advantage of, and while the calculations here can be extremely complicated, and we don’t even have complete information to do so, there are some rules of thumb that can be used to help people decide.

The Process of Deciding on a Traditional IRA

Once we have decided upon a certain allotment to our retirement that we may put in an IRA, we then have to decide on whether the particular benefits of a traditional IRA will be persuasive enough to want us to contribute to one, either with all of our IRA contributions or some part of them.

Expecting a reduction in one’s marginal tax rate is one of the biggest factors that are looked at, and is the primary one that financial advisors rely on, although this isn’t the only consideration. Expected rate of return is another influential factor, and not one that tends to be recognized enough.

The reason why this particular feature matters is when we compare a traditional IRA with a Roth IRA, a traditional IRA speaks to both the principal and interest, where a Roth IRA is only concerned with sheltering the interest from taxation.

With both types, at the time of withdrawal, there will be a certain portion of the account that will represent the principal contributions that are made to it, with the rest being a result of the returns that have been gained over time.

With a strategy that will produce a lower rate of return, where for instance a total gain of 50% is realized, our tax savings with a traditional IRA will be the reduction in tax realized on the entire amount. There are other benefits as well with a traditional IRA, but the primary focus is on saving tax ultimately on this total amount.

A Roth IRA only addresses the earnings of the account and the principal is tax neutral, as we are subject to paying the full tax on contributions in the year that the income is earned. We could therefore say that the higher the proportion of earnings that there ends up being in the account in the end, the greater the relative benefit of a Roth IRA.

If instead of our 50% overall return, it ends up being 200%, then we now have four times the return and four times as much of our account benefiting from this amount being tax free with a Roth IRA, instead of the amount of tax just being reduced by virtue of a lower marginal tax rate in retirement.

In practice though, with the majority of people investing their IRAs in mutual funds with a modest expectation of returns, along with the expectation of paying a lower percentage in income tax when withdrawn, this does have the two coming out pretty close. We do need to be aware though that those who use more conservative investment strategies will generally be better off with a traditional IRA, all other things being equal, with those who expect higher returns than normal generally benefiting more from a Roth IRA.

The likelihood that we may need to tap into our IRA savings prior to retirement will matter as well, and those who have little savings apart from their IRA may want to lean toward a Roth IRA more, since the funds in this type of IRA are more accessible. With a Roth IRA, you are only penalized for withdrawing the earnings of our IRA early, where with a traditional IRA, the entire amount is subject to a 10% penalty for early withdrawal, prior to the age of 59 ½.

It’s not a good idea generally to withdraw a traditional IRA prior to retirement regardless of age, given that the main idea behind it is to cash it in at a lower tax rate. We could be in our 60’s and not pay any withdrawal penalties but still lose out on tax savings if we take money out of it, where with a Roth IRA, there are no tax consequences at all of withdrawing any amount after age 59 ½.

How Traditional IRAs Help Us Stay the Course

Ideally, we should be set up so that we can actually wait until retirement to withdraw anything from any form of IRA, although this is all going to depend on how much money we have overall to operate with.

It’s a nice position to be in to have plenty of money to deal with whatever contingencies come along, especially ones that we may anticipate or have a reasonable likelihood of occurring, and those of significant means may be able to manage this without much trouble.

We need to keep in mind though that both main forms of IRAs are targeted towards those of more modest financial means, and while some may view the contribution limits as being rather small, for those whose income qualifies them to put money in an IRA, it can represent a significant percentage of it.

We may be putting in 10% or even 20% of our gross income in an IRA, which often will represent a substantial or even very substantial portion of the money that we may allot to savings. This can leave us with a shortfall in non-retirement savings, and while we often will borrow as the needs arise to handle these contingencies, even borrowing for everyday things if we do not heed this enough, borrowing and saving at the same time often is not a good idea.

This is not to say that we should never borrow and contribute to an IRA at the same time, and if the interest rates we pay is low enough the costs of this can be minimized, and we may end up benefiting overall, but we don’t want to do too much of this and especially not pay too much in interest because of this.

Roth IRAs can help us manage these contingencies, but on the other hand, if the funds are more readily available, this can encourage us to spend our retirement savings more capriciously, using them for spending of a more discretionary nature, and undermine our retirement plans as a result.

Given that people tend to spend too much generally, the stronger barrier that traditional IRAs erect in comparison to Roth IRAs as far as access to our retirement money can certainly be a benefit and help many people stay the course.

When you withdraw early from a traditional IRA, not only are you subject to the 10% penalty, you also have to declare the amount withdrawn as income. Often times, this not only does not result in the tax savings that was behind the strategy of the account, it may result in one paying even more if their tax rate has increased.

We do tend to make more money over time and it is certainly possible that you may pay a higher rate of tax on money withdrawn from a traditional IRA later, which is far from desirable.

These consequences do serve to give people plenty of pause for thought when it comes to deciding whether to take money out of a traditional IRA before the intended time, and if this means that they will be less likely to do so unless truly needed, this can be a great benefit for those who may not have the proper amount of discipline.

Many people are in a position where they may want or need to be more aggressive with their savings allotments as far as contributing to retirement plans, where they may need to contribute a larger amount to it and keep less aside for other things, and therefore put themselves at a higher risk of needing it later as a matter of strategy.

In these cases, it can be wise to use a hybrid strategy, putting enough into a Roth IRA to accommodate these needs, money that they may otherwise want to keep in a regular account. This can yield a strategy with three components, a contingency fund which they likely will need, money in a traditional IRA which they should never need until retirement, and the remainder in a Roth IRA which they probably will not need but just might.

If we are worried about spending any of this and want to close the door more on any impulses we may have to do the wrong thing, then a traditional IRA provides this benefit, and we then should allot whatever money we wish to have this added protection with to that account.

Traditional IRAs are a great vehicle which essentially allow us to borrow money from the IRS that we would otherwise have just handed over to them, and keep it for many years to help us with our retirement, as well as paying less of it back than we borrowed.

This leads to several important benefits, as we may then invest this borrowed money over time and make good money from it, we may pay back less than we borrowed and add to this profit, as well as seeing the amount that we need to pay back depreciate over time.

To illustrate this, let’s say that you contributed $5000 to a traditional IRA 30 years ago, where you would have paid, say, $1000 in tax. You now declare the $5000 as taxable income, and let’s say your tax rate has stayed the same, so you now have to pay the $1000 tax on it. $1000 is worth quite a bit less these days than it was back then, so you actually pay back less in real dollars even though the nominal amounts are the same. This is a benefit that we don’t consider enough and actually is one of the main benefits of a long-term traditional IRA.

Traditional IRAs can be a great way to save for retirement, as an adjunct to whatever plan you have at work, in conjunction with a Roth IRA, or even as a stand-alone plan.

Robert

Editor, MarketReview.com

Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.

Contact Robert: [email protected]

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