- Part or all of your annual IRA contribution may be tax deductible on a federal level. In general, how much you can deduct is determined by your income and whether you participate in an employer-sponsored retirement plan (such as a 401(k) account). Your personal tax adviser can better explain how the Traditional IRA's tax-deductibility rules affect you.
- All gains from your IRA, such as capital gains, dividends or interest, are tax deferred until you make withdrawals. This means more money will be available to generate growth.
This chart below compares a deductible Traditional IRA investment of $3,000 made at the beginning of each year with an annual nondeductible investment of $3,000 made into a taxable investment account at the beginning of each year. For both accounts, assume a hypothetical growth rate of 8 percent and a 28 percent federal tax rate.
More about the assumptions:
Your actual tax rate on the withdrawal of gains from a tax-deferred1 account could be more or less than 28 percent, depending upon the applicable tax rates that are then in effect, and whether you make your withdrawal in a lump sum or over time. Your effective tax rate on gains from a taxable account could also be more or less than 28 percent, depending upon your adjusted gross income and the nature of the gains. All dividends and capital gains during accumulation in a tax deferred account are deferred until such time you begin to make withdrawals. At that point you will pay ordinary income tax based on your federal and state income tax rates.
Capital gains taxation is not available for gains taken from a tax-deferred account. The differences between the tax-deferred and taxable returns shown in the example would therefore be smaller if (a) your effective federal tax rate on the gains from a taxable account were lower than 28 percent or (b) your federal tax rate on a withdrawal from a tax-deferred account were greater than 28 percent.
The hypothetical 8 percent investment return is compounded annually and assumes reinvestment of dividends and capital gains
The value of the Traditional IRA after a lump sum withdrawal taxed at 28 percent is $33,794 if taken after 10 years, $106,753 if taken after 20 years, and $264,267 if taken after 30 years.
Hypothetical results are for illustrative purposes only and are not intended to represent the past or future performance of any specific securities. Investment return and principal will fluctuate so that shares, when redeemed, may be worth more or less than their original value. Withdrawals before age 59½ may be subject to ordinary income tax and a 10 percent penalty.
Changes in tax rates and tax treatment of investment earnings may impact the comparative results. Each investor should consider their personal investment horizon and income tax bracket, both current and anticipated when making an investment decision as these may further impact the results of the comparison.
1Tax deferred refers to investment earnings such as interest, dividends or capital gains that accumulate tax free until the investor withdraws and takes possession of them.