In a previous column, I asserted that all pilots need to maximize contributions to a Roth IRA each year. In this column, we’ll see why by examining three ways to invest $6,000:
- A taxable brokerage account.
- A Traditional IRA
- A Roth IRA
We’ll assume all three cases invest these funds the same way: in a low fee total stock market index fund that (conservatively) earns us a 5 percent annual return. This means that after one year, our $6,000 balance increases by $300 to $6,300. Compounding interest means we earn more per year the longer our money stays invested.
| Years Invested | Account Balance |
|---|---|
| 0 | $6,000 |
| 5 | $7,658 |
| 10 | $9,773 |
| 20 | $15,920 |
| 30 | $25,932 |
| 40 | $42,240 |
Awesome, right? You could have spent that $6,000 renting an airplane for 40 hours this year, or you could spend $42,240 on 281.6 flight hours in the future.
Before we rush to spend our money though, let’s see how tax rules play into each case.
Case 1: Brokerage Account
The money in our brokerage account gets taxed twice. First, we’ll have to pay income tax on our $6,000 as part of this year’s tax bill. For today’s race, we’ll assume you have an entry-level pilot job, probably putting you around the 12 percent tax bracket. This means you’ll have to pay $720 in taxes this year on this $6,000 you invested.
When you cash out investments in a brokerage account, thankfully, you don’t pay income tax on that money again. Instead, you pay what’s called capital gains tax. There are only three brackets for this tax:
- 0 percent
- 15 percent
- 20 percent
Which bracket you fall into depends on your income. Most end up in the 15 percent bracket, so we’ll use that. If you waited a full 40 years to cash out your $42,240 worth of investments, you’d pay $6,336 in capital gains tax.
Total tax paid: $7,056 ($720 + $6336)
Total gain after taxes: $35,184
You’ll probably also get taxed annually on dividends paid by the companies in which you own stock. We’ll ignore these taxes and discuss them in a separate article.
Case 2: Traditional IRA
Your traditional IRA is “before tax” money, so you don’t have to pay any taxes on your $6,000 this year. This leaves you with $720 cash that you won’t get in either of our other cases. You could spend that money, but we’re going to assume you do something better with it. You’re going to invest that $720 in a taxable brokerage account, just like you did with your other money in Case 1.
Years from now, the money you pull out of your traditional IRA does get taxed as earned income. If you have a high salary at the time, this means you’ll take a big hit. We’ll assume your pay has increased to put you in the 24 percent tax bracket. The $42,240 in your traditional IRA now gets hit with a whopping $10,137 income tax bill. Ouch!
Over 40 years, that extra $720 you invested has also grown to $5,069. Thankfully, 15 percent capital gains tax on that only comes out to another $760. This case yields an extra $4,309 (after taxes) we get to add to the balance in our traditional IRA.
Total tax paid: $10,897 ($10,137 + $760)
Total gain after taxes: $36,411
Case 3: Roth IRA
Taxes for the Roth IRA are opposite those of the traditional version. We have to pay 12 percent income tax on our original $6,000, or $720. However, once that bill is paid, we never pay another penny of tax on our Roth IRA money again.
Total tax paid: $720
Total gains after taxes: $41,520
Roth IRA Wins, Right?
In our example, the Roth IRA is the clear winner no matter how many years you have until retirement.
| End Balance After Taxes (Summary) | |||
|---|---|---|---|
| Years Invested | Brokerage Account |
Traditional IRA | Roth IRA |
| 5 | $5,789 | $6,601 | $6,938 |
| 10 | $7,587 | $8,425 | $9,053 |
| 20 | $12,812 | $13,723 | $15,200 |
| 30 | $21,322 | $22,353 | $25,212 |
| 40 | $35,184 | $36,411 | $41,520 |
However, that doesn’t always hold true. Let’s look at a couple specific situations:
Situation A: Regional Airline Captain
A long-time regional airline captain’s annual income should be in the low six figures, putting them in the 24 percent tax bracket. If that pilot plans to move up to a major airline and significantly increases their income to the 32 percent tax bracket, the Roth IRA only makes sense if the money will stay invested long enough.
| End Balance After Taxes (Summary) | |||
|---|---|---|---|
| Years Invested | Brokerage Account |
Traditional IRA | Roth IRA |
| 5 | $5,069 | $6,769 | $6,218 |
| 10 | $6,867 | $8,640 | $8,333 |
| 20 | $12,092 | $14,073 | $14,480 |
| 30 | $20,602 | $22,924 | $24,492 |
| 40 | $34,464 | $37,340 | $40,800 |
If this is an older pilot who is closer to mandatory retirement age, he or she may need to start withdrawing from the Roth IRA in fewer than 20 years. In this case, he or she is better off putting this year’s money into a traditional IRA.
Situation B: Fully Retired
Our other cases all assume we’d start withdrawing funds from our retirement accounts while still earning high salaries. This isn’t entirely unrealistic. Even an airline pilot could continue making great money flying Gulfstreams for a corporate or charter operator well into his or her 70s.
That said, many of us will choose to quit full-time work a little sooner. Most pilots are ready to retire by 50 or 55, and I don’t know many who actually last until 65. Upon retiring, you no longer earn an active income from a job. Instead, you just live off your investments. You only need to withdraw as much money from those accounts each year as you need to cover your basic needs and hopefully enjoy some unnecessary wants too. Most people could have a great retired life while only drawing enough money from retirement funds to hit the 12 percent or 22 percent income tax brackets.
It turns out that if you plan to retire and stay in a tax bracket at or below the one you were in when you were actively working, a traditional IRA actually wins in most cases. Here’s our last chart showing you in the 24 percent tax bracket when you put the money into your retirement account, and in the 22 percent tax bracket when you withdrew it. Even with a difference of just 2 percent, you’re better off investing in a traditional IRA.
| End Balance After Taxes (Summary) | |||
|---|---|---|---|
| Years Invested | Brokerage Account |
Traditional IRA | Roth IRA |
| 5 | $5,069 | $7,535 | $6,218 |
| 10 | $6,867 | $9,617 | $8,333 |
| 20 | $12,092 | $15,665 | $14,480 |
| 30 | $20,602 | $25,517 | $24,492 |
| 40 | $34,464 | $41,564 | $40,800 |
The Only Loser
I hope you noticed that one of these cases never wins this race. No matter what your tax situation may be, or how long you can let your money sit, you’re always better off putting money into some type of IRA account.
This means the only true loser is the pilot who isn’t contributing to an IRA right now!
As long as your taxable income is below the limits, you need to be contributing to an IRA account. Don’t worry if you don’t know how; I’ll cover that in an upcoming article.
You may hear some people complain that money in an IRA is “trapped.” Those people are wrong. I’ll cover why in the future, too.
You may also know people who don’t contribute to an IRA, claiming they can get better investment returns in things like real estate or cryptocurrency. First, although that may be possible, you need some serious education before you can get those returns with those investments. (Yes, we’ll cover how eventually.) Also, there’s a great thing called a self-directed IRA. You can use that unique type of IRA to invest in whatever you want: stocks, bonds, real estate, Bitcoin, gold bars, and much more. We’ll cover this option, too, but you really should start with a plain old IRA for now.
Next, we’ll look at a variety of ways to invest the funds in your IRA. We’ll start with some simple solutions you can use until you can find anything better (and you probably can’t).
Jason Depew flies as a captain for a major U.S. airline. He is also an Air Force reservist and has flown more than 300 combat missions over Afghanistan and other garden spots. Based in Tampa, Florida, he instructs in the Icon A5 and anything else he can get his hands on. His writing is focused on personal finance for pilots with the goal to help all types of aviators enjoy great careers, sometimes in spite of themselves. You can send Jason questions at [email protected].
