Illinois Extension

Dear Karen,

You mentioned that putting my long term savings into an IRA could save me some money on income taxes. How would that work?

Your Young Friend

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Dear Young Friend,

If you put your money in a regular account – say, one that you set up with a mutual fund company – you will owe taxes each year on any income in the account. That could be interest, or dividends that stocks pay, or the gain (profit) on any stocks or bonds that were sold inside the mutual fund.

But if you tell them that you want to open a Roth IRA instead of a regular account, you won't ever pay tax on the income in the account. Being an IRA doesn't change what investments you can have in the account, it just changes how the money is taxed.

If you told them to make it a traditional IRA instead of a Roth, you'd get income tax savings now instead of in the future. The money you put in a traditional IRA would be deducted from your income this year. You wouldn't pay tax on that money – or on the growth in the account – until you took it out. That's called tax deferral. And just FYI – people who have a retirement plan at work and make more than $61,000, may not be able to deduct their contribution to a traditional IRA.

Mathematically, those two tax breaks are equal if everything else stays the same. Which one is better depends on the situation. My guess is that the Roth would be a better choice for you. Here's why:

• You're just starting your professional career, so your income is relatively low right now. That puts you in a low tax bracket, and the tax savings you'd get by deducting a contribution to a traditional IRA would be small. It's likely that you'll be in a higher tax bracket when you're older. Being able to take money out of the Roth IRA then, without owing any tax on it, will be a much bigger advantage.
• Tax rates can change. If they go up, you'll be glad to have money you can take out tax-free.
• A Roth IRA has one feature that is different from any other retirement account. You can take your contributions out any time, without any tax or penalty. All the other retirement accounts have penalties if you take money out before age 59 ½; you'll owe income tax plus a 10% penalty. Age 59 ½ is a long way off for you, and who knows what could happen between now and then? So the Roth IRA gives you a lot of flexibility that the other retirement plans don't. If you really need the money, you can take out everything that you put in. At any time. No taxes. No penalties. If you take out more than the amount that you contributed, you'll be dipping into the earnings or the growth in the account. If you take that money out and you aren't yet age 59 ½, then you'll owe income tax and a 10% penalty. But that doesn't happen until you've taken out every penny that you contributed.

There's another tax reason you should think about putting money into some type of retirement account, and that's the Saver's Credit. You can get this Credit no matter what kind of retirement plan you contribute to, as long as your income qualifies. The Credit is subtracted from your income tax. You can contribute up to $2000 and get a credit of 10%, 20% or 50% of that amount, depending on your income. (Married couples filing jointly could take the credit on up to $4000.)

Here's the chart from the IRS:

So let's say your Adjusted Gross Income is $25,000, you're single so you look at the All Other Filers column, and you put $2000 into an IRA. Your credit would be $200, or 10% of $2000. When you do your income taxes, you will get an extra $200 refund from the IRS. The only time you wouldn't get the refund is if you didn't owe that much tax to start with.

If you're eligible for the Saver's Credit, it's like someone is giving you a bonus. You deposited $2000, but it really only cost you $1800 to do it!

Karen

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This post continues a series based on conversations with a young friend of mine about the financial decisions and challenges of being an independent young adult in today's world. You can find other posts in the series by clicking Organizing Finances in the Category list on the right side of this page. ~Karen