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Why an IRA Tax Deduction May Not Be Your Best Move

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Let's face it: Most people open IRAs not out of any great desire to save for retirement but rather because they offer a quick way to get a lucrative tax break. What you may well find, though, is that choosing a retirement account simply to get an IRA tax deduction could end up costing you a whole lot more in taxes down the road.

Fortunately, there's an alternative that lets you turn the tables on the IRS, paying an up-front cost now in order to save a whole lot more on your tax returns in the future. Before getting to that, let's take a look at what's involved in deductible IRAs and why so many people just take the money and run.

IRAs, deductions, and you
Traditional IRAs allow you to contribute up to $5,000 for the 2012 tax year, plus an additional $1,000 if you're 50 years old or older. If you meet certain requirements, you'll be able to deduct that contribution on your tax return.

The requirements differ depending on your income and filing status, as well as whether you (or your spouse, if you're married) are eligible to participate in a 401(k) or other employer-sponsored retirement plan at work.

Let's start with the simplest cases. If you're single and don't have a retirement plan at work, or if you file jointly and neither you nor your spouse has an employer plan available, then you can deduct your contribution regardless of how much income you make.

For those covered by employer-sponsored retirement plans, the math gets trickier. Single filers making more than $68,000 in adjusted gross income aren't allowed to take an IRA deduction. For joint filers, the limit is $112,000. In each case, you'll only be eligible for a partial deduction if you make slightly less than the limit -- within $10,000 for singles or $20,000 for joint filers.

Finally, if you're not covered at work but your spouse is, then a higher limit applies. If your total adjusted gross income is $183,000 or more, you won't be able to deduct your IRA contribution. Under $173,000, you'll get a full deduction.

Why you might not want the deduction
Even if you're entitled to an IRA deduction, though, you may prefer a different choice: namely, a Roth IRA. That's because in exchange for giving up your deduction, you instead get the benefit of tax-free withdrawals after you retire.

To understand why a Roth IRA may be more valuable, consider the way traditional IRAs work. You get an upfront deduction, but you have to pay tax at regular rates when you pull your money out. Not only will your original contribution get taxed but also every bit of income and price appreciation your investments generated.

The more successful your investments, the bigger a deal that is. For Monster Beverage (Nasdaq: MNST  ) , American Tower (NYSE: AMT  ) , and Titanium Metals (NYSE: TIE  ) -- all of which have posted gains of at least 5,000% over the past 10 years -- the difference is staggering. For Monster, at top tax rates, you would pay nearly 60 times your initial investment in taxes alone. With American Tower and Titanium Metals, the corresponding figures are about 20 times and 16 times your initial purchase.

Of course, much of those returns come from having perfect timing in buying near the bottom of the bear market in 2002. Yet while these results are extraordinary, you'll get similar if somewhat smaller benefits with a wide range of investments. Expand your time frame to 20 years -- just half the length of a typical career -- and more mainstream stocks IBM (NYSE: IBM  ) and Procter & Gamble (NYSE: PG  ) reveal the value of the Roth IRA.

Think twice
With their own income limits, Roth IRAs aren't available to many high-income taxpayers. But interestingly, the less you make, the better off you are with a Roth, because the deduction you give up at the beginning is worth correspondingly less for low-bracket taxpayers.

So instead of just opening a regular IRA and taking the immediate tax break, think about whether a Roth IRA would be a better long-term move. In the end, a Roth could save you a whole lot more in taxes.

In an IRA, the best investing approach is to choose great companies and stick with them for the long term. In our free report "3 Stocks That Will Help You Retire Rich," we name stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.

Fool contributor Dan Caplinger has no positions in the stocks mentioned above. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of IBM and Titanium Metals. Motley Fool newsletter services recommend American Tower, IBM, Monster Beverage, Procter & Gamble, and Titanium Metals. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (2) | Recommend This Article (5)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 30, 2012, at 11:28 AM, teebob21 wrote:

    Don't forget: If your tax bracket does not change between your career and your retirement, Roth vs traditional IRA is irrelevant. You should take the tax break when your effective rate is highest. For most people this is during prime working years; or maybe you have such a fat retirement that it is during retirement. Or if you have several children, your deductions and credits may make your lowest effective rate happen early in your career.

    Here's the math, using some of the author's assumptions (25% tax bracket):

    Roth IRA: $10000 of investable income, $2500 paid in tax up front. $7500 investment grows 5000% to an account balance of $375,000, which can be withdrawn as tax-free income.

    Individual IRA: $10000 of investable income, $0 paid in tax up-front. $10000 investment grows 5000% to an account balance of $500,000. This is withdrawn with a tax rate of 25%, resulting in $375,000 of spendable after-tax income.

    That said, the Roth has other advantages, such as access to contributions without penalty before retirement.

  • Report this Comment On October 30, 2012, at 3:44 PM, tk77mann wrote:

    GREAT Analysis, teebob. Many, many investors do not realize there is no net difference in after-tax return if the person's tax rate does not change.

    That said, with Roth IRAs there is also the advantage of having more manageability of withdrawals to help reduce taxes. After 59 -1/2 you can withdraw as much as you want from a Roth IRA without paying any more taxes. (You paid all the taxes up front as you deposited the money in the account, of course.) And you do not have to ever withdraw from the account (except when you pass away).

    In a traditional IRA, after age 72 you have to withdraw an IRS-specified minimum (unless you want to pay expensive penalties), and it will be taxed at your marginal tax rate, which is always your highest rate for that year.

    Also in a traditional IRA, if you need extra money in any one year from your account, taking more than the minimum might push you into a higher tax bracket.

    Roth IRAs also let investors adjust their retirement deposits according to the current federal income tax rates. In years where the current tax rates are low (read:now, for many folks), it makes sense to put retirement savings into a Roth IRA since it is likely federal income tax rates will increase in the future.

    In years when the federal tax rate is high, or if an investor has a special circumstance increasing their salary income which pushes them temporarily into a high tax bracket, then putting retirement savings for that year into a traditional IRA makes sense since in the future the tax rate for that investor will likely decrease when they have to withdraw the money.

    One of the best things I ever did was fund Roth IRA accounts for my kids when they worked in high school and college. Their tax rates were low, and they hopefully will have many decades' worth of dividends and compounding to grow their retirement funds. They kept all of their after-school earnings, and never knew they had Roth IRA accounts. In ~35+ years they hopefully will be happily surprised when they realize their Old Man took care of them 40+ years ago.

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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