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January 02, 2008

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I expect taxes to continue rising as well, but I certainly wouldn't recommend cashing in a traditional IRA to move money into a Roth IRA! There is a good chance congress will tax ROTH withdrawals at some point in the next fifty years.

I am very new to trying to get a bootstrap hold of my personal finances.

That being said, I am 29, have a wife, one child and one on the way. My wife doesn't work and I make close to 100k. I have been horrid with savings.

I just started funding my 401 to the match, adjusted my withholdings and take home stays roughly the same (actually up a bit). With my tithes, interest, property taxes and child number 2 and a stay at home wife (for now) the IRS calculator told me to take something like 12.. I took 6 because I just don't believe the calculator.

I am also transferring money to my ING account automatically now (trying to build up the emergency fund) and with this years tax refund and some extra side projects, I expect to be CC debt free (yay! that leaves 2 cars and a mortgage though, the extra CC money will go to one of the vehicles - which I will for the first time actually try to drive past my loan).

So I have an interesting choice this year. I can still afford to start an IRA (or pump up savings, save a couple months of my aggressive CC paydown). I was thinking I should start a Roth IRA and try to fund it every year that I am able. Doing that would give me a tax benefit at retirement. The other side of that argument is I could start a Traditional IRA for my wife and end up contributing more because I'll increase my refund.

I am thinking that for me, getting that additional bump from the Traditional should help me now which actually will help me later (I will have contributed more than I could have otherwise).

Will tax rates go up dramatically in 30-40 years? Who knows. I don't think we will see a dramatic rise, the current trend has seen the lower brackets reach expanding. By the time I retire, I plan to continue my tithing and offering (and I'll be able to give more hopefully free from the burdens of a mortgage). That should help me offset. I also am not looking to expand my lifestyle in retirement. I would probably be okay withdrawing the minimum distributions and I don't think the tax burden would kill me.

I will someday fund a roth just to have a bit of an extra tax free at retirement cushion but probably focus more on my 401/Traditional IRA for the next 5-10 years to maximize what I am putting down. Even if taxes still go up, I should be alright in my mind.

Interesting article. I do agree that converting a Traditional IRA to a Roth and paying all the taxes now is a pretty risky strategy. Unless you are really young or have a pretty low balance it doesn't seem to make much sense.

Obviously there are a ton of factors that go into this decision, from guesses on tax rates, to contribution limitations, employer match percentages, etc. Lots of grey areas, to be sure.

It's a tough call. It would be nice, if the tax code would "sponsor" just one kind of retirement plan instead of a ton of them.
I don't think a massive calculation is required for any estimates. Since people are still fervently debating which one is better, the answer is that overall they're equally good and choices depends on specifics. I'm taking a radically different approach. Most of my money is in taxable accounts which is useful because after 2009, capital gains taxes are 0% if your income is kept under $15000. That should not be too hard, hehehe ;-)

I am only 23 right now, so I've been doing the "young people thing" and have been investing in a Roth IRA. My company is a startup, so they don't match 401k contributions. I've been erring on the low side for 401k contributions because I'd like to be able to pay off my student loans a little faster (a guaranteed return of a decent amount considering how high my student loan rates are). I like telling people that I'm diversifying my retirement fund tax responsibilities, though who knows if that's actually true. I'll be eligible for Roths for quite some time, since I'm not near the cap yet, and not near marriage yet, either!
I feel like it's a good method for now...I think once my loans are paid off, or there's another big change in my life (marriage, job change, home purchase) I'll probably take another look and what I'm doing...but in the meantime, I'd like to think I'm doing okay.

I work in the financial services industry and my company has a calculator we can do for clients letting them know if they would benefit from converting their Traditional IRA to a ROTH. I haven't used the calculator a lot, but I have NEVER had anyone's calculation come out that they should convert. At best, it is sometimes a wash.
In my own retirement planning, the idea in this article is what has kept me from moving my contributions to the ROTH 401k that my company started offering last year. I decided to keep my 401k contributions (I just put in enough to get the match) as tax deferred and put my IRA money into the ROTH. That way, at retirement, I'll have some money that's already been taxed and some that will be taxed at the current rate. I'm 27 now, so retirement is a long way off. I hope my strategy works out ok!

Arguing about which vehicle to save money in is like a 400 lb man arguing about whether to start the Atkins or South Beach diet. Just freaking do something.

If you're doing the following, you don't need to worry about anything else:
(1) Be debt free, with the possible exception of a mortgage.
(2) Make your contributions to retirement savings, including employer matches etc, equal to 15% or more of your income.
(3) Put all of our savings into tax advantaged accounts until they have no more capacity -- only then should you save in taxable accounts.
(4) Make sure the bulk of your money is in stock index funds.

Once you're doing that, why make the rest of your life focused on planning for the rest of your life? Just start living!

I believe it's a good idea to hedge your options both ways. I do follow the strategy of investing in 401(k) until you meet the company match, then invest in a Roth. However, I don't think it is wise to convert an IRA to a Roth. There's just too many unknowns that the future can bring (i.e. tax rates, congress could change the laws, etc).

Tim

I agree with hedging your bets, but I also agree a dynamic approach is likely the best. Just starting out? In a low bracket? A Roth it is. Worked all year? In a high bracket? Traditional. Unemployed half the year? Consider converting some from Traditional to Roth if you can pay the taxes on it. Constant income? Stay Traditional.

There's no discussion in the article about the difference *after* retirement. I have a Roth because it is much easier to plan around. For one, a Roth has no mandatory withdrawals. Assuming there are income-based taxes, you can much better manage your tax burden if you have some tax-free money to play with. For example, if you want to buy a new car or house with cash, you don't have to mess around with taking it out in small amounts over years to avoid jumping to a higher bracket. If you don't need/want to take anything out, you can leave it there growing tax-free for as long as you want.

A Roth is also a good secondary emergency fund. Five years after opening the Roth I can take money out without any penalty up to the amount I previously contributed. However, unlike a taxable account, the money in the Roth is protected from creditors (at least in Michigan where I live) should I go through a bankruptcy, just like money in exempt retirement accounts.

Finally, I have no heirs but for those who do I understand at present at least there are some inheritance-related benefits to a Roth should you want a place to accumulate funds to pass along to your children.

My biggest concern with the Roth is that, given the apparent general lack of retirement planning, somehow a non-income-based tax will be implemented to fund some variant of social security to support those who did not prepare themselves. That would in effect tax me twice by taxing my contributions going in, then an end run indirect tax on the distributions as well.

I admit I have both kinds of IRA, but only contribute to the Roth. The other is for rolling over 401(k) money from previous employers.

I am all about the ROTH IRA. Anything you put in if you need that money there is no penalty.

Take the free money if your company is giving it to you.
Fund your ROTH IRA, and save save save...

I agree tax diversification is the best way to hedge your bet. I have been weighing the pros and cons between funding a 401(k) or a Roth 401(k) and posted my thought process on this a while back.

Its tough to give up that tax break now.

The hybrid option makes the most sense to me. Like DC Smith said, there are more benefits to a Roth vs a traditional IRA than just the taxes. Being able to withdraw your contributions without penalty more than makes up for the tax deferral of a traditional IRA.

Likewise, the ability to take as much (or little) out of a Roth once you reach retirement is great for planning your income and controlling taxes in retirement, or passing wealth along to your heirs. I also work in the financial industry, and of all my older clients with traditional IRA's, none of them like having to take required distributions when they don't need the income.

The tax advantages of a traditional IRA/non matched 401k during high income years are pretty substantial too though. I have both, and plan to use both, based on my income. It's risky to give up the guaranteed tax advantage of a Traditional now, and risky to give up the tax and other advantages of a Roth later. Classic hedge time!

The real advantage comes from using both. Traditional when in a high tax bracket and converting to a Roth when you know you are in a low one. It may be hard to predict what tax bracket you will be in, but it is easy to know which one you are in. You can even spend a few years converting some of it between leaving work and the onset of other pensions and Social Security if you like.

One big problem with 401k are(at least with my employment) is the expense ratio. We are with ing and the lowest expense ratio is 1.00%. With some going as high as 1.84%. When you can fund your roth's outside this in vanguard at around .2-.3% expense ratios then what ever the differnce is in extra money compounded is eaten away by the expense ratio. This may just be at my employment but that is what I have noticed here lately.

I like IRAs over non-matching 401Ks because, as mentioned above, you can invest in whatever you want rather than only within the limits of your employer's plan. Generally this means you can find investments with much lower fees and sometimes you can find ones that better match your philosophy on growth versus safety.

Also, as mentioned above, you have a lot more flexibility in taking your money out with an IRA than with a 401K.

Any time you change jobs, I highly recommend rolling your 401K into an IRA.

I also believe that taxes are going nowhere but up (especially for me since I'm currently in the 15% bracket). Also, I really don't see that Roths will be taxed in the future, because that is double-taxing. However, there is a possibility that Roth holders will be screwed anyway (again, as mentioned above) if, for example, income taxes are reduced and sales taxes are increased.

For that reason, I also believe that diversity is good. Since I have a big pension, which will be taxed, all of my other money is in Roths. Because some of my retirement income (the Roth stuff) is pre-taxed, the remainder will add up to less than it would otherwise, thus likely leaving me in a lower tax bracket.

I also just converted a regular IRA to a Roth IRA. I had a small pension at another employer, so I converted it to an IRA and then to a Roth IRA (two steps were required in my situation). This was a good decision for me because a) it was a small amount which I could easily afford the taxes on, b) I'm in a low tax bracket, so it's cheap for me, and c) the vast majority of my retirement funds will still be coming from my taxable pension, so this helps balance my risk.

(Note: if your traditional IRA is so big you can't afford to roll it over without withdrawing some of the money from it and paying fines and taxes on that, you can roll over just part of it each year.)

And, as also mentioned above, all these choices are good. If you pick the "wrong" one, you are still good, with the possible exception of if you pick something with fees so high that you end up losing money. There's also nothing wrong with not using a retirement fund at all--you still pay taxes, but (except for interest) it's at dividend and capital gains rates which, at least now, are lower than income rates. The most important thing by far is to save a reasonable amount of money on an ongoing basis.

Finally, I take issue with the first quoted paragraph. First of all, you should just contribute however much you can reasonably afford, whichever method you use. So, in this example, if you can spare $6000, that will put $6000 into a traditional fund or $4000 into Roth fund. The traditional fund will then get much huger than the Roth fund, but you don't get to have all that money--it will be taxed. If you have the same tax rate, you will end up with the same amount of after-tax money at the end. So letting your eyes get all big at the bigger number is not appropriate.

Do you want to be Taxed on $4000 now or Taxed on $40,000 later?

Regular IRA if you put in $4000 and let it accrue for 20 years and it grows to $40,000. You will be taxed let's say 15% of 40k=$6000 cost to you.
vs

Roth IRA put in $4000 pay say 30% on 4000 = $1200. If it grows to $40,000 over 20 years? Your tax is still $1200.

hmmmmm do I want to pay $1200 now or $6000 later? yeah I want to spend $4800 MORE. or 400% more taxes.
Oh and let the government try to change the tax rule on Roth IRAs. They will have a mob of angry citizens who will never trust the government again. And a new Al Quada in America.

Really depends on income and time to retirement; also what you do with tax savings from putting money in 401K. Since contributing to 401K is before taxes, why not put the tax savings into Roth IRA? This way you'll have both. If you end up spending tax savings frivolously, putting money into Roth may be a better idea. If you have a real need of this money, than 401K is better. Additionally, as your income gets higher, you might not even be able to contribute to Roth IRA unless your income is reduced by your 401K contribution.

I was in this situation in 2005 and 2006. The only thing that allowed me to even put money in Roth IRA was maxing 401K. This year I'd be in phase-out range even with max 401K contribution, but I also have capital gains from selling a little under 20% of my ESPP stock; so now the only question I have about Roth IRA is if I can trust the government not to change the provision of removing income limits on conversion in 2010. But then, if I am lucky, my max 401K contribution may help me avoid AMT or at least reduce it. As I plan to continue with selling ESPP stock - way too much money there - I'll probably be in the same boat next year.

So I don't think there is one right answer for everyone.

For things to even come CLOSE to being even with a Roth and Traditional account, you'd have to invest all of the tax savings you get from the Traditional investments. And never touch those savings. And get higher rates of return on those savings than the money in your Roth since to counter the taxes you'll be paying on them. And who, exactly, is going to do that?

Secondly, most people choose an amount they can afford to invest: $2000 or 6% of their salary, for instance. They aren't considering that since their take home pay will be less affected by a Traditional contribution that they can actually afford to contribute $2500 or 8% of their salaries now (which is allegedly one of the primary benefits to a Traditional account accd to the post).

I put the max into my 401k, and I have been putting the max into my regular IRA. However, my AGI for last year is expected to be in the region where the deductability of my IRA contributions gets phased out. As a result, from first pass through my numbers, I'm going to have to recharacterize some? all? of my IRA contributions and call them Roth-IRA contributions.

It isn't a matter of "one is better than the other" as I'd like to take the deduction now, and sock away as much as possible for retirement. It looks like several of the above posters are in the situation where they're beyond the deductability limits for IRAs.

My advice would be to max out one's 401k contribution without regard to the employer match. As a payroll deduction, they'll be automatic and as a result, you won't "accidentally" spend the money. In my small office, I'm the only one putting the max into the 401k. Many of the others are putting zero.

Note: I spent almost 2 years out of work due to the messed up IT economy between 2001 and 2004. So 2005 was the first year since 2001 that I had been putting retirement money away, and last year was the first year I could max out contributions. I am in my late 40s and it looks like I need to put aside the max possible for the next 20 years, as my earlier investments were very bad when they were done at all.

I have been contributing to my company ESOP and 401K up to the match. Next was the Roth Ira. Now my company offers an Roth 401K with a match. I am all over that. My taxable accounts are out pacing my Roths. I think having Roth accounts and non-Roth accounts are the way to go. Diversification has always been preached for your nest egg.

Just wanted to point out that The Financial Engineering pointed out that 'To retire early, you must invest in assets that are held in taxable accounts.

With the economy the way that it's been the past few years, it's hard to get any sort of savings going, let alone worrying about roth vs 401k contributions to a retirement plan. I have been lucky enough to weather the economic storm pretty well with the help of Steidle Pension Solutions. Keith has been a great advisor and all of his staff are great to work with.

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