Think Twice Before Contributing to a Traditional IRA
It’s tax time once again, which
makes it the perfect time to discuss what, in my humble opinion, seems to be
one of the deadliest financial mistakes that millions of unsuspecting folks are
led to make by some tax preparers.
Right about now, so many folks are
being given what amounts to very short-sighted advice to make tax-deductible
contributions into traditional IRAs so that they can reduce their taxes (a.k.a.
save money and, in turn, outsmart our favorite Uncle Sam). On the surface, that
sounds like a pretty awesome situation, doesn’t it? But that is not the end of
the story. In fact, from my standpoint, it is not even half of the story.
First of all, it is true that once
you meet certain criteria, you are allowed to make tax deductible contributions
to an IRA. Presently, it’s up to $5,500 for those under age 50 and $6,500 for
people 50 and older. So, yes, by doing so, you would be reducing your taxes,
all things being equal, but only for today.
However, here’s the rest of the
story – the alarming part that people often discover so many years later to
their utter dismay, at least based on what I keep seeing in my practice year
after year.
Your contributions to a
traditional IRA and the interest you earn on them accrue on a tax-deferred
basis. In everyday English, all you are doing is essentially electing to
postpone paying the taxes you owe until sometime in the future, probably when
you reach retirement age. So you really aren't avoiding any taxes – they all must
be paid sooner or later.
So when you reach retirement age
and begin taking withdrawals from your traditional IRA, every single penny will
be subject to taxes – get this – at whatever tax rate you find yourself in at
that point in time. An amazing number of people tend to think that when they
retire, they will somehow find themselves in a very low tax bracket because
they expect a drop in their total income. But it is not as simple as that,
because that is not how income taxes work. We are taxed on our “taxable income”
– not simply income, two entirely different concepts.
And I can tell you this also. Generally
speaking, you tend to have very few deductions in retirement, compared to
earlier on in life, so your taxable income – like that of most retirees in
America today – will likely be higher than you anticipate, even though you have
a much lower total income. I am not sure if you’ve noticed it yet, but most
folks in retirement tend to not enjoy tax time at all. Not that most of us look
forward to it, but per my observations, retirees really, really dread April 15.
Another caveat. All the withdrawals
you take from your traditional IRA in retirement also factor into how much tax
you’ll end up paying on your Social Security benefit checks. I am not sure any
of these traditional IRA gurus tell folks about this piece of crucial tax
planning information.
To be clear. I am not telling you
that you should not own a traditional IRA, because I simply don’t know your
particular situation. I am suggesting, however, that you be mindful of the
often one-sided view offered by typical financial advisors and consider the
total picture. At the end of the day, when the rubber finally meets the road,
as it always does, you are not saving because you want to defer taxes, but because
you want to have income available for a better tomorrow.
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