One question often raised by those with an income that places them in the highest tax bracket is, “Should I make an IRA contribution each year?” For this article, we define a high-income earner as an individual or couple who makes more than $200,000. The question of whether to make an IRA contribution is easy for those earning less—the answer is almost always “yes, make a contribution.” However, if the Roth IRA is no longer an available option (phased out starting at $107k in Adjusted Gross Income for singles, $169k for married filing jointly) and current tax benefits are not available for Traditional IRA contributions, the question is a little tougher to answer. Let us look at the benefits and drawbacks to both approaches—making a contribution or not making a contribution.
If a high-income earner decides to make an IRA contribution, the contribution cannot be made to a Roth IRA. Instead it must be made to a Traditional IRA. Let’s assume that in this earner’s situation, the contribution is not tax deductible. Once the funds are in the IRA, they will grow tax-deferred until withdrawn. At withdrawal, if the IRA has gained value, a portion of the distribution will be a tax-free return of contribution, with the remainder taxed at the current income tax rate of the recipient.
The tax-deferred growth is the primary benefit of the Traditional IRA for someone who does not receive any tax benefit for the contribution. The investor can make changes to the investments inside the IRA over the years with no capital gains tax due. Additionally, dividends are paid without being taxed as regular income.
The primary drawback for this investor is that the growth portion of the distribution is taxed as regular income rather than as a capital gain. In addition, a distribution from the IRA before the investor reaches age 59½ may be penalized with a 10% tax penalty in addition to the regular income tax.
If no IRA contribution is made, the cash could be invested in a taxable investment, such as shares of individual stocks, mutual funds, bonds or cash funds. In any case, unless the investment is specifically tax-free, e.g., municipal bonds, any time an investment is sold, the long-term capital gains taxes must be paid on any increase in value for securities held for more than one year. In addition, dividends and interest are taxable each year, as they are paid. One benefit to this approach is that there are no limitations to how soon the investor can access the funds without penalty, as with the IRA.
As you can see, there are benefits to each approach—either making or avoiding an IRA contribution. Henssler Financial recommends making a Roth IRA contribution each year, if at all possible. However, the firms’ opinion regarding Traditional IRA contributions has changed over the years. In some cases, even if you do not receive a tax deduction for your Traditional IRA contribution, this still may be a viable option for you. Effective last year, there is no income restriction for converting your Traditional IRA to a Roth IRA. If the Traditional IRA consists of mostly after-tax contributions, this should be more appealing since the taxes owed should be minimal. However, if your Traditional IRA is largely made up of pre-tax contributions, it may not make sense to convert to a Roth IRA if you incur a large tax liability. For those who cannot take the deduction, another option is to invest the funds in a taxable account.
What happens to capital gains and income tax rates in the coming years will ultimately determine which approach would have provided the higher after-tax return. Since there is no way to predict future tax rates, an investor should consider both approaches, weigh the benefits to each and pick whichever approach seems better for them. High-income investors should also consider the frequency of trading expected and their own feelings about future tax rates. For more information regarding this topic, please contact Henssler Financial at 770-429-9166 or [email protected]