ROTH vs. Traditional IRA

[beth_leonard]

As a result of a book I still haven't finished, I started looking at the ROTH vs. Traditional IRA question differently.

Basic primer:
ROTH IRA - you put after-tax money in now, the money is not taxed when you take it out.
Traditional IRA - you put pre-tax money in now, you are taxed on the distributions when you take them out.

At first I thought of it as a tax bracket gamble, will you be in a higher or lower tax bracket when you retire, but now I see why it's so much better to go with a ROTH, especially if you have extra money for your day-to-day needs.

To make the math easy, assume you are in the 50% tax bracket now and also will be when you retire. The maximum you can contribute to an IRA (any type, combined) in 2007 was $4000. Assume for the sake of argument that you only invest in one mutual fund which exactly triples over the life of your investment. On the one hand, the two choices seem mathematically equivalent.

Case 1: You put $4000 into a traditional IRA. It triples to $12,000. You withdraw it and pay $6000 to the government and get to keep $6000 for yourself.

Case 2: With your $4000 you pay $2000 in taxes to the government and invest $2000 in a ROTH IRA. It triples to $6000 and later you withdraw it and keep the whole thing.

You have the same amount of money for retirement either way, right? Well... let's look at case 3 and case 4, the cases when you have more than $4000 (say $8000) of earned income to invest now.

Case 3: You put $4000 into a traditional IRA. On your remaining $4000 you pay $2000 in taxes and invest the rest in the same investment. When you withdraw the funds from the IRA as in case 1 you pay $6000 in taxes and keep $6000. For your other money, you will be paying capital gains taxes on the $4000 increase in the value of the investment. For the sake of argument, assume cap gains is 10% then. The grand total you have to spend is: $6000 + $6000 - $400 = $11,600.

Case 4: You put $4000 into a ROTH IRA and pay $4000 in taxes. Your money triples. You pay no taxes when you take it out and now can spend $12,000.

...
So effectively, using a ROTH now allows you to shelter more of your money. It is most effective of course if you expect to be in a higher tax bracket when you retire than now when you are earning money.

--Beth

Comments

[songmonk.livejournal.com]

Your math looks right to me, but something isn't sitting right. But I can't think of what.

And that's working under the set of assumptions you have laid out. (Which is entirely legitimate to illustrate the differences between Roth and traditional IRAs.)

But practically speaking the income limits may make the choice academic. For example, b/c my employer has a 401(k) plan, at my income level I am illegible for a fully deductible traditional IRA, but I can make a full Roth IRA contribution.

Another factor which you addressed but may not be realistic is that your tax bracket is normally assumed to be lower at withdrawal since you are typically have less earned income.

Then again, who knows what the legislators will do to tax brackets by then which makes it a gamble as you stated on which way you think tax rates will go.

Chris like ROTH

[nemene.livejournal.com]

Another factor under the current system is SS benefits. In retirmenr, your SS benefits are tax free as long as your TAXABLE income is lower then a certain threshold, and for every dollar more then then that a dollar of SS becomes taxable. So for a while your effetive tax rate is twice your bracket. Traditional IRA and 401k installments count toward taxable income, ROTH does not. This means if you want to have an income higher then the SS threshold you are well advised to have some of your retirement income come from a ROTH type account. (BTW employers now have the option to offer a ROTH 401k)

[(Anonymous)]

I think the argument you just made is that using ROTH IRA incurs fewer taxes than just investing that money, not that ROTH incurs less tax than traditional. To strengthen that argument, you could also consider when the taxable events occur in ROTH and non-IRA investment -- in a traditional investment, your capital gains tax may hit at several intermediate stages, rather than being lumped at the end as in your scenario. I would argue that effectively you end up paying (taxes) for flexibility in the use of funds.

--Rob

[beth_leonard]

I'm not sure I understand, are you arguing against maxing your ROTH? or just that some other stratgy is optimal? If so, what strategy?
--Beth

Re: Chris like ROTH

[beth_leonard]

I hadn't known that about SS income. Good tip!
--Beth

[robszewczyk.livejournal.com]

I'm not arguing against IRA or ROTH. I believe that your analysis above showed that ROTH allows you to shelter more money than a non-IRA investment, not that it allows you to shelter more money than a traditional IRA.

[robszewczyk.livejournal.com]

Does your argument assume a limit of 4K contribution to both ROTH and traditional IRA?

[beth_leonard]

It doesn't assume that, it is that. Or was for 2007. I believe it is $5000 for 2008. That is the total amount you can contribute to both types of IRAs combined (assuming your AGI is low enough (< 160K? ) and your earned income was high enough (> 4K after Social Security taxes).

Which is why I believe that a ROTH really does allow you to shelter more money than a traditional IRA.
--Beth

[nemene.livejournal.com]

A ROTH does shelter more money then a traditional. Lets say person A and person B both max out their IRAs. A has traditional B has ROTH. Person A gets a tax credit now, this is his advantage. When they bpth get to retirement it looks like they have the same amount of money in their accounts. But when person A pulls money out he has to pay taxes on it, this means he get less out of it, or his account is worth less then Person B.

[robszewczyk.livejournal.com]

Right. I missed the part with hard limits on contribution. With ROTH you need more money to play initially, but as a result of the limits it gives you more money in the end.