Financial Advice - Traditional vs. Roth IRA

The Coffee Shop
1

So my wife and I just did our taxes and we’re getting screwed as usual because we’re DINKs (dual income no kids) and we are trying to find some ways to save. We’re considering buying a home to cross over the standard deduction barrier to where we can itemize, but until then we’re just looking at 2008 taxes.

If anyone can offer some thoughts or suggestions I would appreciate it! My wife and I both currently have traditional IRAs (past rollovers from old employer 401ks) and both also have Roth IRAs with low balances (we contribute as much as the employer will match at work and put the rest in the Roth IRAs). We currently are not contributing any additional to our traditional IRAs and they are growing just from earnings.

We haved owed about $2,000 the last couple of years and this year is no different. It’s not like we didn’t KNOW we were going to owe this year, but I would rather keep my money all year than pay extra taxes each month to the government. So anyway, I was trying to compare scenarios and have been getting lost in the details. But here is what I came up with:

Since traditional IRA contributions are tax deductible my wife and would both contribute $4,000 each for a total for $8,000 into our traditional IRAs, this would result in not having to pay $2,000 in taxes, but a small return of $500, so essentially a gain of $2,500. We would then reinvest the $2,500 gain, and take that on our taxes for next year, 2009. So I would be looking at a total traditional IRA investment of $10,500 (we do not reinvest the tax deductible savings for 2009 on the $2,500 reinvestment). I plug this in an online calculator, say I’m 30 years old, 35 years of growth, retire at 65, 8% average return with all else equal, no other contributions, no inflation, no withdrawls, etc. Total comes to be $106,000, post tax (33% bracket) of $71,000.

Now I compare that to placing $6,000 ($8,000 principal on hand minus the $2,000 we owe in taxes). In a Roth IRA, assuming the same of a retirement bracket of 33%, 8% average, 30 years investment, retire at 65, the online calculator shows $60,376.

So with this formula, I would come out ahead with the traditional IRA at $71,000 vs the Roth at $60,376. What am I assuming wrong here and what am I missing? I’m sure something, any help would be great. It looks as if I would HAVE to reinvest the $2,500 in tax deductible savings to come out ahead with the traditional, otherwise the Roth would trump. Thanks for the help!

2

So my wife and I just did our taxes and we’re getting screwed as usual because we’re DINKs (dual income no kids) and we are trying to find some ways to save. We’re considering buying a home to cross over the standard deduction barrier to where we can itemize, but until then we’re just looking at 2008 taxes.

If anyone can offer some thoughts or suggestions I would appreciate it! My wife and I both currently have traditional IRAs (past rollovers from old employer 401ks) and both also have Roth IRAs with low balances (we contribute as much as the employer will match at work and put the rest in the Roth IRAs). We currently are not contributing any additional to our traditional IRAs and they are growing just from earnings.

We haved owed about $2,000 the last couple of years and this year is no different. It’s not like we didn’t KNOW we were going to owe this year, but I would rather keep my money all year than pay extra taxes each month to the government. So anyway, I was trying to compare scenarios and have been getting lost in the details. But here is what I came up with:

Since traditional IRA contributions are tax deductible my wife and would both contribute $4,000 each for a total for $8,000 into our traditional IRAs, this would result in not having to pay $2,000 in taxes, but a small return of $500, so essentially a gain of $2,500. We would then reinvest the $2,500 gain, and take that on our taxes for next year, 2009. So I would be looking at a total traditional IRA investment of $10,500 (we do not reinvest the tax deductible savings for 2009 on the $2,500 reinvestment). I plug this in an online calculator, say I’m 30 years old, 35 years of growth, retire at 65, 8% average return with all else equal, no other contributions, no inflation, no withdrawls, etc. Total comes to be $106,000, post tax (33% bracket) of $71,000.

Now I compare that to placing $6,000 ($8,000 principal on hand minus the $2,000 we owe in taxes). In a Roth IRA, assuming the same of a retirement bracket of 33%, 8% average, 30 years investment, retire at 65, the online calculator shows $60,376.

So with this formula, I would come out ahead with the traditional IRA at $71,000 vs the Roth at $60,376. What am I assuming wrong here and what am I missing? I’m sure something, any help would be great. It looks as if I would HAVE to reinvest the $2,500 in tax deductible savings to come out ahead with the traditional, otherwise the Roth would trump. Thanks for the help!

I would max out your 401k(s) to the extent possible ($16,500 contribution each for 2009) before putting any money into a ROTH or a Traditional IRA. Once you do that then max out the Roth, then think about the traditional.

3

My Roth calculator shows you get $88,712 from the Roth scenario ($6K, no contributions, 30 years, 8%). There’s no taxes on the Roth withdrawals, is my understanding.

And I think you’re cheating a little bit on the standard IRA math. You’re including the $500 interest in the math, but that interest is already factored in by an interest calculators, so you’re getting double interest in that first year unless you accounted for that.

4

Sounds like you know your investment options pretty well, but one thing I’d point out (because it isn’t clear what your AGI is from your post) is that those traditional IRAs may not be fully deductible since you are eligible and participate in your employers’ 401(k) program. I believe that if you’re filing Married Jointly returns in 2009, if your AGI is between $89,000 and $109,000 you can take only a partial deduction, whereas if your AGI is greater than $109,000 you get no deduction.

5

Hmm, that is a good point, I’ll double back and check the deduction rules in regards to what we already put in our 401k. In regards to the other post, I also thought it better to stop investing in my 401k at the point in which my employer will stop matching because I have much more freedom in either of my IRA’s with investment choices. My current employer offers only 13 mutual funds and a few bond funds vs. thousands of choices in the open market.

But I guess now that I think about it, if my 401k had a significantly larger balance and the principal was growing, the interest would grow it faster, then say if my IRA had a low balance, e.g. an 8% average on $20,000 (example 401k) is much better compounding and growing with future contributions, than an IRA with an 8% average on $5,000 (example IRA) that isn’t getting as much contribution as the 401k.

Argggggg…this frustrates me, maybe I should just find a good investment advisor!

6

Sounds like you know your investment options pretty well, but one thing I’d point out (because it isn’t clear what your AGI is from your post) is that those traditional IRAs may not be fully deductible since you are eligible and participate in your employers’ 401(k) program. I believe that if you’re filing Married Jointly returns in 2009, if your AGI is between $89,000 and $109,000 you can take only a partial deduction, whereas if your AGI is greater than $109,000 you get no deduction.

Good point Steve, thus another reason to max the 401K first. The traditional does phase out for higher income earners but there is a wrinkle in 2010 that will allow high income earners to convert traditional IRA’s into a Roth.

http://money.cnn.com/2008/11/28/smallbusiness/roth_return.fsb/index.htm

The issue of whether to max the 401k first or go for the Roth depends on your situation and what you think you future tax status will be, among other things.

7

Sweet! You gotta love the InterWebs… I’ll need to discuss this with my financial guy, but this looks like a great opportunity… particularly since my IRA investments are worth less than half what they were 1.5 years ago. Present tax liability will be much lower. Hmmmmm.

8

Hmm, that is a good point, I’ll double back and check the deduction rules in regards to what we already put in our 401k. In regards to the other post, I also thought it better to stop investing in my 401k at the point in which my employer will stop matching because I have much more freedom in either of my IRA’s with investment choices. My current employer offers only 13 mutual funds and a few bond funds vs. thousands of choices in the open market.

But I guess now that I think about it, if my 401k had a significantly larger balance and the principal was growing, the interest would grow it faster, then say if my IRA had a low balance, e.g. an 8% average on $20,000 (example 401k) is much better compounding and growing with future contributions, than an IRA with an 8% average on $5,000 (example IRA) that isn’t getting as much contribution as the 401k.

Argggggg…this frustrates me, maybe I should just find a good investment advisor!

That is a perfectly legitimate and all too common issue with 401k’s. My employer offers a brokerage option in the 401k plan so I can invest in individual securities, although the negative of this is that I lose the ability to harvest tax losses. By contributing the max to your 401k you are then able to adjust your withholding in order to get more into your paycheck up front and in certain instances depending on where you fall on the marginal tax bracket chart your incremental contribution–whether maxed out or not–can keep you from jumping up to a higher bracket, which can be a big savings. My approach and philosophy is to focus on tax minimization first.

9

Sweet! You gotta love the InterWebs… I’ll need to discuss this with my financial guy, but this looks like a great opportunity… particularly since my IRA investments are worth less than half what they were 1.5 years ago. Present tax liability will be much lower. Hmmmmm.
Not a lot of people know about this, but at least for now this loophole will be available. You will have to take the tax hit up front but the long term math works in your favor. I plan to convert and for most people if they can offset the liability this is indeed a sweet deal.

10

Steve is right. If you are currently in the 33% bracket, your AGI will be too high to deduct IRA contributions given your comment that you are actively participating in your employers’ 401k plans. Although, if you are in the 33% bracket, you make too much to do Roth IRA contributions too (33% bracket starts at taxable income of ~$200K, Roths are gone at AGI of $176K). So something doesn’t jibe.

Also, I’d say there is nothing wrong with only having 13 options in your 401k. As long as some of them are good options…

As to the Roth vs Regular IRA, I think that if you stay in the same tax bracket your entire life both options work out the same in the end from an income tax perspective. If you’ll be in a higher or lower tax bracket during retirement (or have other, non-income tax, reasons) one option may be better for you than the other.

11

“As to the Roth vs Regular IRA, I think that if you stay in the same tax bracket your entire life both options work out the same in the end from an income tax perspective. If you’ll be in a higher or lower tax bracket during retirement (or have other, non-income tax, reasons) one option may be better for you than the other.”

Wouldn’t a Roth be a wise choice for someone who may want to take out a large amount all in one year? Maybe the purchase of a motorhome, vacation property, etc?

12

So I did some more research based on some of the suggestions and I don’t qualify for tax deductible IRA contributions, but I still qualify for Roth contributions. So while that doesn’t solve my tax problem, at least I know I can’t do anything about it with additional IRA contributions.

So right now my plan will be to contribute to the 401k at work maxed up to the employer match, then try and max out Roth contributions before I can’t qualify anymore. Back to where I started!

13

Sounds like you know your investment options pretty well, but one thing I’d point out (because it isn’t clear what your AGI is from your post) is that those traditional IRAs may not be fully deductible since you are eligible and participate in your employers’ 401(k) program. I believe that if you’re filing Married Jointly returns in 2009, if your AGI is between $89,000 and $109,000 you can take only a partial deduction, whereas if your AGI is greater than $109,000 you get no deduction.

Good point Steve, thus another reason to max the 401K first. The traditional does phase out for higher income earners but there is a wrinkle in 2010 that will allow high income earners to convert traditional IRA’s into a Roth.

http://money.cnn.com/...return.fsb/index.htm

The issue of whether to max the 401k first or go for the Roth depends on your situation and what you think you future tax status will be, among other things.
Holy crap.You made my day.

14

Sounds like you know your investment options pretty well, but one thing I’d point out (because it isn’t clear what your AGI is from your post) is that those traditional IRAs may not be fully deductible since you are eligible and participate in your employers’ 401(k) program. I believe that if you’re filing Married Jointly returns in 2009, if your AGI is between $89,000 and $109,000 you can take only a partial deduction, whereas if your AGI is greater than $109,000 you get no deduction.

Good point Steve, thus another reason to max the 401K first. The traditional does phase out for higher income earners but there is a wrinkle in 2010 that will allow high income earners to convert traditional IRA’s into a Roth.

http://money.cnn.com/...return.fsb/index.htm

The issue of whether to max the 401k first or go for the Roth depends on your situation and what you think you future tax status will be, among other things.
Holy crap.You made my day.
The tougher decision is whether or not to add MORE $ to the traditional this year in order to maximize the conversion even though I won’t be able to deduct that amount on my taxes. I wonder if this too good to be true loophole gets closed?? : (

15

Certainly, there are instances where a Roth would be better than a regular IRA. In your examples, for instance, the Roth may be a better option. The risk with the regular IRA is that the withdrawals may cause you to move up a tax bracket (or two), or may cause your social security to be taxable when it otherwise might not be. Of course, then my statement “if you stay in the same tax bracket your entire life” no longer applies. :slight_smile:

I’m a big fan of “tax diversification”. I don’t know what the tax code will look like in 40 years when I retire, but having some assets in a Roth, and some in a regular IRA, and some in my 401k, and some in an after-tax account should give me the ability to use the most tax efficient account when I need the funds.

16

Certainly, there are instances where a Roth would be better than a regular IRA. In your examples, for instance, the Roth may be a better option. The risk with the regular IRA is that the withdrawals may cause you to move up a tax bracket (or two), or may cause your social security to be taxable when it otherwise might not be. Of course, then my statement “if you stay in the same tax bracket your entire life” no longer applies. :slight_smile:

I’m a big fan of “tax diversification”. I don’t know what the tax code will look like in 40 years when I retire, but having some assets in a Roth, and some in a regular IRA, and some in my 401k, and some in an after-tax account should give me the ability to use the most tax efficient account when I need the funds.
This makes sense to me, and is currently how I am operating. I’m only 26 years old and in 40 years everything will have changed… I can worry less right now about forecasting what the change will be and focus on saving in investment vehicles, whatever they are.