Question

In a traditional IRA account, a

$1000.00 investment is taxed at 12%.
In a Roth IRA account, the $1000.00
investment is taxed at 10%. Which
plan reduces the overall tax burden?
A. The Traditional will reduce the tax burden because it's applied at a
higher percentage.
B. Both tax burdens will come out the same since both tax
calculations start with a $1000.00 account.
C. The Roth IRA reduces the tax burden because its taxes are
calculated in a lower bracket.
D. The Traditional IRA reduces the tax burden because its taxes are
calculated in a lower bracket.

Answer 1

C. The Roth IRA reduces the tax burden because its taxes are calculated in a lower bracket.

In a traditional IRA, contributions may be tax-deductible in the year they are made, but withdrawals in retirement are taxed as ordinary income. This means that the $1000.00 investment in a traditional IRA would be taxed at the investor's ordinary income tax rate when it is withdrawn in retirement. If the investor's ordinary income tax rate is 12%, then the tax burden on the $1000.00 investment in a traditional IRA would be $120.00.

In a Roth IRA, contributions are not tax-deductible, but withdrawals in retirement are tax-free. This means that the $1000.00 investment in a Roth IRA would be taxed at the investor's ordinary income tax rate when it is made, but it would not be taxed when it is withdrawn in retirement. If the investor's ordinary income tax rate is 10%, then the tax burden on the $1000.00 investment in a Roth IRA would be $100.00.

Overall, the tax burden on the $1000.00 investment in a Roth IRA is lower than the tax burden on the same investment in a traditional IRA because the taxes on the Roth IRA are calculated in a lower bracket (10% vs 12%).