How to Calculate an Optimal Tax-Neutral IRA Contribution

by Mike Parker

There are two basic types of individual retirement accounts: traditional IRAs and Roth IRAs. One primary difference between these two types of accounts involves when your funds are taxed. Contributions to traditional IRAs are made on a tax-deferred basis, while contributions to Roth IRAs are made with after-tax dollars. When considering whether to contribute to a traditional IRA or a Roth IRA you should consider whether the contributions will be tax-neutral in the long run.

Determine your tax rate for the year in which you wish to contribute to your individual retirement account. Tax laws and regulations are subject to change throughout the year. Fortunately, you are able to contribute to your IRA up until the original due date for filing your taxes, which is typically April 15 of the following year. You will have time for Congress to finalize any last minute changes to the tax code, and to figure all of your income taxes, less your IRA contribution. Once you know your taxable income, you can determine your rate by comparing your taxable income to the Internal Revenue Service's tax brackets.

Determine the amount of money you wish to contribute to your IRA. Compile two columns for your calculations on a sheet of paper; one column for a traditional IRA and one column for a Roth IRA. Record the amount of your contribution in both columns. Multiply the amount in the traditional IRA column by zero, since you will be able to deduct this amount from your taxable income, and record the result. Multiple the amount in the Roth IRA column by the percentage of your tax rate. Subtract the result from the amount of your contribution. The result is the amount that you have left to contribute to your Roth IRA, since you must pay taxes on the original amount.

Determine the average rate of return you expect to receive on your contributions to your IRA. Apply a compound interest formula to the amounts you have available to contribute. The compound interest formula will vary based on how frequently your interest is compounded and how many years you intend to leave your contributions in your IRA. Record the yearly results in both your traditional IRA and Roth IRA columns.

Multiply the yearly results in your traditional IRA column by your anticipated tax rate and record your results. Multiply the yearly results in your Roth IRA column by zero, since you will have no tax obligation on qualified withdrawals from your Roth IRA. The variance between the yearly amounts will continue to decrease as the number of years increase, and will eventually reach equality, resulting in your optimal tax-neutral IRA contribution.

Tip

  • Compound interest provides the greatest return opportunities for those who invest early in life.

Warnings

  • Early or non-qualified withdrawals from your individual retirement account will result in a significant tax penalty.
  • Past performance of any investment is never a guarantee of future results.

Items you will need

  • Calculator with a compound interest formula

About the Author

Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.