Is Tax Deferral All It’s Talked Up To Be?

As the tax filing deadline approaches, there is the inevitable dash to fund 2006 IRA’s before April 15th. After all, a $4,000 deductible IRA contribution could save you $1,000 on your 2006 federal taxes if you are in the 25% bracket. Sounds great, doesn’t it; but how many people are really eligible for this contribution?

As a married, joint filer, for 2006 if your adjusted gross income was over $123,701 ($74,201 for single filers) then you will have income taxed in the 25% bracket. If you are not a participant in a company sponsored retirement plan, such as a 401(k) or pension plan, then you are eligible to make this deductible IRA contribution. But should you?

(If you are a participant in a company sponsored plan, then the ability to deduct an IRA contribution was phased out when your adjusted gross income exceeded $85,000 ($60,000 for single filers).)

The answer is: it depends. If you find yourself in a higher tax bracket at the time you take distributions from your IRA, there was minimal benefit to the tax deferral, meaning you had accumulated about 3-6% more money over a twenty year time horizon than if you had saved the money in a non-deductible, after-tax account.

On the other hand, if you find yourself in a lower bracket at the time you take withdrawals, or even in the same bracket, the tax deferral helped you accumulate 15-25% more money over a twenty year time horizon.

This analysis says that if you plan on success, and a progressively increasing income, tax deferral helps, but will not provide as great of an advantage as if you were in a lower bracket in your later years. So what are your alternatives?

A ROTH IRA allows you to make after-tax contributions and once the funds are in the ROTH they grow income tax free. To be eligible to make a ROTH contribution, as a married filer your adjusted gross income had to be less than $160,000 for 2006 ($110,000 for single filers).

The benefits of the ROTH are exactly the opposite of the deductible IRA. If you find yourself in a higher bracket at the time you take distributions from the ROTH, the tax free growth helped you accumulate 15-20% more money than using the deductible counterpart.

On the other hand, if you find yourself in a lower bracket at the time you take distributions, the after-tax contributions and tax free growth in the ROTH did not provide any added benefit; as a matter of fact you may have less total money accumulated than if you had made deductible IRA contributions.

Sounds confusing? It is. The true answer is, if we all knew exactly what our tax bracket we would be each year, making these decisions would be easy. A crystal ball could give you the perfect answer. Can’t find one of those? The next best thing is to have a qualified financial planner run a projected cash flow with a year by year tax analysis.