Because contributions to and earnings in an Individual Retirement Account (IRA) are not taxed until the funds are withdrawn at retirement, an IRA offers many Americans an opportunity to accumulate retirement funds at an accelerated rate. But individuals should conduct a detailed analysis before deciding whether or not to establish or continue investing in an IRA. In certain circumstances, the individual would be better off with an equivalent investment that is not sheltered from taxes.
If the individual’s tax bracket during retirement is equal to or less than his tax bracket during his working years, the IRA will always prove superior to an equivalent, nonsheltered investment, because taxes will reduce the amount that can be invested in the latter. On the other hand, the nonsheltered plan could prove superior if a large proportion of total return is in the form of capital gains, which in the case of the IRA would be taxed as ordinary income, or if the retirement years’ tax bracket exceeds the working years’ tax bracket.
The last result may not be uncommon. A 35-year-old worker who invests $2,000 each year in an IRA that earns 15 per cent annually will have accumulated $869,000 by age 65. Withdrawing funds over 15 years gives him approximately $149,000 of taxable income—enough to put him in the maximum tax bracket. Thus the only situation in which the investor can be sure the IRA is the preferable choice is when he is in the maximum tax bracket during his working years.