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May 21, 2007


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I have two thoughts on this, I'll post them in two separate comments:

1. This would only work for a handful of people, however I might be one of them, so it's something I've thought about: I think the ideal situation would be to initially fund a traditional IRA and take the immediate tax-savings. Then, in a year when you won't have much income (i.e. If you go back to school for MBA full time) convert it to a Roth. That way, in the year of conversion the income will be taxed at a lower rate and you of course avoid tax at retirement.

2. More universally, I agree with your comment that they seem to ignore the issue of tax at retirement, however, they also don't mention the return over time of the money you're saving in taxes now by going with the traditional. Let's say you invest the $1,000 tax savings in an index fund until retirement (Not sure how he comes up with a $2,333 tax spread, isn't it only $1k?) and your investments across the board are earning 10% over 30 years. That breaks down as:

Roth: 4,000 invested gets you: $69,798; not taxed = $69,798

Trad: 4,000 invested gets you: $69,798; taxed 25% = $52,348
Indx: 1,000 invested gets you: $17,449; taxed 25% = $13,087

Total Trad = $65,453

So in this case Roth wins, but not by a whole lot, and there seems to be more upside in the case of the traditional (i.e., index will probably be taxed at capital gains, tax bracket overall could be lower at retirement, and I could be missing something and the initial tax spread really could be $2,333).

Personally, I say invest in the traditional until your income level forces you to the Roth.

I don't disagree with the logic in the least. I never thought that the ROTH was the best thing.

BUT I am in a 10% tax bracket - so it is a no brainer. It really really really depends on your situation. I have to make like $4400 to put away $4000. Big whoop. Plus if you are a good investor it could really pay off. What if I make 10% per year gains and get to withdraw those gains tax-free in retirement.

Which reminds me the other reason a ROTH is much more lucrative to the younger crowd. I have a 40 year+ horizon to retirement. IT makes much less sense for those closer to retirement, with less time to compound earnings.

Then again I don't really expect the ROTH laws to remain unchanged for the next 40 years. I don't think the government can afford it if all the young people today took advantage. They may limit contributions or phase it out eventually. I would never put all my eggs in one basket for this reason. But I certainly take advantage now with youth and low tax bracket on my side. If I was in the 25% bracket I would probably split my money between the two, as I don't really see a real clear winner. I did Traditional IRA until we cut back our income for kids. Now we are converting them all to ROTHs and taking advantage of the low tax rates. I think the odds are pretty good we'll never have such a low income tax rate again - we make good money - just a lot of deductions with kids and mortgages.

Interesting topic, and one that I've thought about a lot. Recently, my employer has offered a choice of a Roth 403-b versus traditional 403-b, which makes the stakes for choosing correctly much higher, since contribution limits for 403-b plans are much higher than for IRAs.

Being somewhat of a mathematically inclined geek, I ran through some 20 year simulations to test the Roth versus traditional approach for various assumptions about future tax rates and investment gains between now and retirement. For my own case, the "traditional" plans appear likely to beat the "Roth" by a significant amount. But the outcome is heavily dependent on present and future tax rates, so your mileage may vary ....

I think that my tax rate after retirement is going to be lower than it is now; this favors using the "traditional" over the Roth. My reasoning is that my current income greatly exceeds my current cost of living (I'm saving a lot). After retirement, I expect my income (from taxable retirement plan withdrawals) will only equal my cost of living, which may be pretty low, since I don't expect to have a mortgage when I'm retired.

As of now, I have both types of accounts, but keep the mix at 80% traditional and 20% Roth. I figure I can withdraw from the traditional account in my low tax years (which I expect to be normal for me), and withdraw from the Roth if I have a high tax year.

- Stopped Clock

I think the author of that article did his reader a disservice. In the simplest of terms, if you can fully fund a roth every year you'll have a LOT more money available to you when compared to fully funding a traditional ira.

The author did correctly notify his reader that you really can't answer the question of which one is better unless you can see into the future, which obviously is impossible. However his reader is 26 and is likely far from maxing out their earning potential. I'd say it's pretty likely that the reader will eventually end up in a higher tax bracket, and remain in a higher tax bracket at retirement.

With the limited information the reader gave, I likely would of recommended a roth. I certainly wouldn't have made it appear there was a $2300 windfall for choosing the traditional, as there is no windfall. The windfall the author describes will disappear when taxes are paid upon withdrawal from a traditional ira.

The author of the article has screwed up logic. He's comparing $3000 after tax to $5333 before tax to get his $2333 difference.

Even if you pay absolutely no taxes on withdrawals from a Traditional IRA because your lifetime savings habits have been so poor that your annual withdrawals are less than your exemptions and deductions, the tax savings are $1000.

Can someone address the $2333 figure? I think it's fuzzy math, and that they're counting the difference twice.

Here was the scenario I ran. Let's say someone made $50K, and he is taxed at a flat 25% rate.

If he went with the traditional IRA:
50000 - Income
4000 - Pretax deductions
46000 - Taxable Income
11500 - Taxes
0 - After Tax Deductions
34500 - Net Income

If he went with the Roth IRA:
50000 - Income
0 - Pretax deductions
50000 - Taxable Income
12500 - Taxes
4000 - After tax deductions
33500 - Net Income

The difference between these two is not $2333. It is only $1000, which is 25% of the money you put into the Roth IRA.

Therefore, there are no tricks. You always pay taxes, either now or later. Sure you can put more money into a traditional IRA now, but you will pay taxes later. It simply matters whether you think you'll be in a higher tax bracket now, or at retirement. Or if you can try a trick like Tim described, that might be a good idea.

An advantage of having both types of accounts is that upon retirement, one could withdraw enough from the "traditional" to just hit the top of the 15% tax bracket (or whatever the relatively low tax bracket is in the future), and then take anything over that from the Roth.

The vast majority of people will be in lower tax brackets at retirement so would do better with a Traditional. They are, however, the ones that likely aren't saving anyway, so those that are saving may well prefer a Roth.

I'm not sure it is a slam dunk that everyone will be in a lower tax bracket than they are today. Yes, you can assume that you won't be withdrawing as much from retirement accounts but tax rates will likely go up in the future.

One more thing to add. The assumption that your income tax rate will be lower in retirement is really faulty. I am a CPA so let me show why.

1 - Incomes tax rates are at historic lows right now

2 - Things people don't consider in retirement that I See with my clients all the time - you will likely be single (widowed or divorced) much of retirement, which today would mean if you had 1/2 the income you had as married you'd still be in the same tax bracket. You brush up against the next higher tax bracket a LOT sooner when you are single. That's unique to today since the marriage penalty was removed though, and will probably be back soon enough. Hard to explain, but makes a difference for now, maybe not for the long-term.

More importantly, in retirement you expect to make a lot less money, but you also lose most of your tax deductions. Just because your income is lower does not mean your taxable income is lower... Most of my six-figure working clients with families are in the 15% tax bracket these days while most my $50k/year retiree clients (most who are divorced or widowed) are in the 25% bracket. The difference is simply the amount of tax deductions.

Very, very few people will make anything near 50k in retirement, very few even make it when working. If you are one and you save a lot then you could well be in a higher bracket even without higher rates.

Roth and Traditional IRAs/401(k)s/403(b)s would come out exactly the same if the tax rate stays the same.

I saw this table somewhere else (wish I could remember where), so I can't take credit for it:

Set aside $5000 to invest
Lose $1250 (25%) to taxes now
$3750 goes into account now
Compound 30 years at 8%, end up with $37,734.96 tax-free

Set aside $5000 to invest
The whole $5000 goes into the account; no taxes paid at this time
Compound 30 years at 8%, end up with $50,313.28 before taxes
Tax nest egg at 25%, lose $12,578.32
End up with $37,734.96 after taxes

The quote in red just plain has its math wrong.

So the only question is whether you think interest rates will be higher in the future than they are now. Considering the social security demographic time bomb and the long-term trend for our government to get bigger and bigger, I'd definitely bet on higher taxes later, especially since I'm young and doing well at saving.

The other advantage of a Roth 401(k) over a traditional 401(k) is for those who max out their savings. Putting the $15,500 limit into a Roth is effectively a lot more money than putting $15,500 into a traditional plan because the Roth contribution is after tax.

There are three advantages of the Traditional IRA that are not usually mentioned by financial planners, most of whom seen to promote the ROTH as always superior.

1.If you build up years worth of contributions in a traditional and then one year decide that the ROTH would be now more appropriate, you can convert amounts from the traditional to the ROTH. However you can't do the same with the ROTH. If you make nothing but ROTH contributions for many years you can't suddenly convert those prior year contributions into a traditional IRA.

2.Traditional IRAs are often more favorable from a state income tax perspective. In Michigan for example your traditional IRA contributions decrease your taxable income in the year you contribute and once you hit 60 years old your distributions are not taxed. ROTH IRA contributions will not lower your taxable income. Thus you get tax benefits twice with the traditional versus only once with the ROTH.

Also many people have to live in high tax states like Ohio during their working years because they are tied down to a particular job but in retirement they can be much more flexible about where they live and move to a state with low or no income taxes like Florida. Such people would benefit more from a traditional IRA because they would avoid tax on both the contributions and withdrawals.

3.Traditional IRAs give you a tax deduction now. Congress can't decide years later to retroactively eliminate this deduction. However ROTH IRAs only give you hypothetical tax benefits years into the future. If the ROTH IRA fell out of favor with lawmakers, your ability to take tax free distributions from your ROTH could come to an end. Former Democratic leader Dick Gephardt is one prominent example of a politician who hates the ROTH and wants to see it eliminated.

The main advantage I see with the ROTH is the ability to take out contributions tax and penalty free during your working years. This makes the ROTH a good hidden emergency fund. For several years in my early twenties I contributed to a ROTH for this reason. Now that I have a comfortable savings cushion and a higher income I am going the traditional route.

So sometimes the ROTH is better and sometimes the traditional is better. There is no one size fits all answer.

Also you are counting only 25% as federal, don't forget state income taxes. Where I am that's another 5.3% taxed on top of it. I do the Roth because we won't qualify for it soon, and because we have a 401k we don't qualify for a deductible IRA. So a Roth it is.

Roth IRAs are good for people under the qualification level, but when you get to the grey area of not qualifying I don't think it's worth it.

It is amazing how many investors and financial professionals believe that Congress will allow the money accumulated in Roth IRA plans to go untaxed. Just look at their track record. They make promises up front, gather in all the sheep, then fleece them. Social Security is a prime example: in 1935 Congress promised the SS tax would never exceed $2.00 (two dollars) per year per worker. Now look at the present level of SS taxes, plus the double taxation on Social Security Retirement Benefits above a certain income level. It's a sure bet that the Roth distributions will be taxed above an income level yet to be determined. I chose the Traditional IRA, and now I'm guaranteed to pay taxes only once. Trusting Congress to refrain from double taxation of a Roth IRA would better be called a Fooledya IRA.

I've been pretty convinced from a friend's spreadsheet that after 30 years of contributions and capital gains, the Roth and Traditional IRAs look pretty equal in the income available to be distributed from them after all taxes are accounted for.

But what these types of arguments always ignore is that your IRA will probably be still generating capital gains for decades more beyond the "30 years". Remember, during this time all contributions have ceased. The distributions being taken from the IRA will probably be low enough so with wise investments the accounts will be actually growing in value for awhile because of these new capital gains. All that new money will eventually have to be distributed from the accounts. And all of it will be tax free from the Roth IRA, while every dime of it will be taxed from the Traditional. This could amount to tens of thousands (and on up) of taxes the holder of the Traditional has to pay, which have no counterpart whatever for the Roth holder. Think about it.

I also don't buy the idea that Congress will one day tax the Roth distributions. Baby boomers who will be taking their tax free Roth distributions will be part of the biggest senior demographic in history, and they won't be shy about voting. And what voting group would Congress get to back them up on such a maneuver? The younger the voters are, the MORE they're participating in Roths.

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