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Roth v. Traditional
Old 11-18-2010, 03:04 PM   #1
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Roth v. Traditional

First post - YEAH!

Rudimentary understanding of investments notwithstanding, I believe a traditional IRA may be superior in my case:

I am in the 25% tax bracket. Investments made into a traditional IRA are deductible. Upon retirement, provided I require <65K annually to live, I will withdraw at the 15% bracket (extrapolated from current tax figures).

If I was to invest in a Roth, it would be at the 25% rate with respect to taxes.

There would seem to be a 10% advantage in favor of the traditional IRA.

Where am I going wrong here?
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Old 11-18-2010, 03:16 PM   #2
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You are assuming that the marginal tax rates will not change in the future. History tells us that this will probably be an invalid assumption, but who knows how they will change. The national debt currently stands at about $13,792,000,000,000. There is a chance that rates may go up.

Notwithstanding changes in tax rates, some considerations:

- your age, and when you expected take money out.

- I assume that you mean you will have less than $65K income, because even if you spend less than $65K you still may have TI above $65K.

- Roths aren't subject to RMDs

- Type of investment within your AA (traditional IRAs turn cap gains and qualified divs into ordinary income)

- You might consider some money in a traditional and some in a Roth as 'tax vehicle diversification'

A traditional IRA may still be the best option for you personally.
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Old 11-18-2010, 03:20 PM   #3
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Where am I going wrong here?
I don't think you're going wrong at all.
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Old 11-18-2010, 03:25 PM   #4
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Welcome to the board

SunsetSail pretty much sums up what I would say. I was never qualified for a Roth until this year so started rolling some over from TIRA's into a Roth. Who knows where tax rates will be when I am 70 and have to do forced distributions. I don't if I'll have time or desire to roll everything over, but I believe in tax diversification.
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Old 11-18-2010, 03:52 PM   #5
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Your analysis is right on the mark! Congratulations for understanding something that most people simply do not, even after it is explained to them. Your understanding of this concept will save you a great deal of taxes over the course of your life.

Actually, the tax benefits are even greater than 10% in your case, and here are the reasons why...(this description is cut and pasted from an earlier discussion):

1) You get an immediate tax reduction equal to your marginal tax rate. If you are currently in your peak earning years, you are probably in a high marginal tax bracket, say 25% or higher, and you will save 25% or more of every dollar you invest in a tax deductible plan. Then, when you retire and begin withdrawing that money, you will pay taxes based on your lower AVERAGE tax rate (aka effective tax rate) in retirement, not your marginal tax rate in retirement. Your average tax rate is almost always lower than your marginal tax rate. For example, a married couple in retirement can withdraw at least $19,000 from their tax deferred accounts TAX FREE because of the standard deduction and their combined personal exemptions. This number may be higher if they have higher deductions or additional tax credits. They could withdraw $19,000 from their tax deferred accounts completely tax free in any given year, and supplement this income with other tax free sources, such as regular savings (withdrawals from regular savings are tax free), or Roth accounts. Even if they withdraw more than 19k in my example, they would only be pushed into the 10% marginal tax rate for the next chunk of income. So they could withdraw say 30k, and pay approximately 1,100 in taxes on the total 30k, which is an effective tax rate of less than 4%! (Remember that they saved 25% of every dollar that they contributed while working, so that is a tax savings of 21%).

If you pay state income tax, your savings are even more dramatic. People who suggest that a Roth IRA and a 401k are a wash if you will be in the same tax bracket in retirement simply don't understand this.

2) Your fixed expenses in retirement may be lower than they are now (no mortgage, no tuition bills or other child related expenses, no car payments, no work related expenses). You will also no longer need to save a chunk of your income for retirement. Therefore, when you retire, you will likely be able to maintain the same standard of living on less income, which means you will be in a lower marginal tax bracket in retirement. If you want to live a more extravagant lifestyle and withdraw money into the higher tax brackets, so be it, you will have that choice. To that extent, and to that extent only, the Roth may prove to be a better choice in the future, but that does not prove that a Roth is better choice as the first option for your investment money now.

3) By contributing to tax deferred plans, you can reduce your current adjusted gross income (AGI) below the threshold at which you can fully take advantage of certain tax credits or tax deductions, such as the child tax credit, or the earned income credit, or the student loan interest deduction, or other credits. If you did not fully take advantage of tax deductible investment plans (and instead contribute to a Roth IRA), your AGI would be correspondingly higher, and you would lose some tax credits, or, the amount of certain tax credits would be reduced. By contrast, investing in a Roth does not lower your AGI.

4) While I agree with the consensus that tax rates will likely be higher in the future, I think it's somewhat naive to have faith that congress will never tax Roth withdrawals, no matter how desperate our government may be in the future for tax revenue. There is a lot of tinkering that can be done in the future, such as reducing the eligibility to take tax free withdrawals, limiting the amount of annual tax free withdrawals, etc. It can (and I think it will) happen.

5) You will retain the option of converting some of your tax deductible funds to a Roth IRA at lower marginal tax rates in the future. For example, you may decide to retire before you are eligible for social security benefits, and withdraw taxable savings to pay your expenses until social security begins. By doing this, you will be using "return of capital" which is not taxed as income, and you may find yourself in a very low tax bracket for a period of time, maybe even a zero tax bracket, and you can use up your lower tax brackets during that time period to convert tax deferred IRAs to a Roth IRA and pay tax on that money at your then lower tax rates. By contrast, funds contributed to a Roth IRA can never be converted to a traditional deductible IRA.


For a more detailed discussion and examples, get the Boglehead's Guide to Retirement Planning, and read chapter 10.
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Old 11-18-2010, 04:18 PM   #6
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Your analysis is right on the mark! Congratulations for understanding something that most people simply do not, even after it is explained to them. Your understanding of this concept will save you a great deal of taxes over the course of your life.
You provide very good examples of situations that may or may not be true, but I think it is dangerous to tell someone that one way is definitely correct when there are many situations where the Roth is the better choice. The abundance use of 'if', 'may' and 'probably' in the examples should have made it obvious that there isn't one right answer here.

To your credit, the situations you described are probably true much (if not most) of the time, but not always. I would hate for someone to make a choice like this without considering all the implications.

An aside question: What high turnout voting block will be upset with tax increases in the greatest numbers (1) income earning workers; or (2) those with $ in Roth IRAs? The answer may tell how the political wind is blowing as to whether Roths are subject to tax vs. marginal tax rate increases. The bottom line is that no one really knows so I hedge my bets with diversification.
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Old 11-18-2010, 04:53 PM   #7
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JustCurious, Excellent post!

Buck Rogers, I've always planned based on the current tax law. There is no way to know what will happen in the future. Who would have guessed in the Clinton years that taxes would go down again?

Also, if you're eligible for a 401-K, your tax-deductible T-IRA contributions will start being phased out. That's a good time to put your money, after fully funding your 401K, in a ROTH.
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Old 11-18-2010, 05:10 PM   #8
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justcurious has laid out long term tax considerations quite well for you. The only thing I'd add, which may or may not be of interest in your case, is that you can withdraw Roth contributions (contributions only - not any earnings) at any time without paying either penalty or taxes. So the Roth can serve as a place to park some emergency funds, rather than having the same sitting in taxable. Your long term tax situation may indeed outweigh any advantage of this potential emergency fund use, but I thought it worth mentioning. It has been a factor in our thinking on this along the way.
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Old 11-18-2010, 06:07 PM   #9
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And it is likely that you can convert your traditional IRA to a Roth IRA in the future when you are in a lower tax bracket, so just because you pick tIRA now does not preclude switching to rIRA in the future.
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Old 11-18-2010, 06:10 PM   #10
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Quote:
Originally Posted by Buck Rogers View Post
First post - YEAH!

Rudimentary understanding of investments notwithstanding, I believe a traditional IRA may be superior in my case:

I am in the 25% tax bracket. Investments made into a traditional IRA are deductible. Upon retirement, provided I require <65K annually to live, I will withdraw at the 15% bracket (extrapolated from current tax figures).

If I was to invest in a Roth, it would be at the 25% rate with respect to taxes.

There would seem to be a 10% advantage in favor of the traditional IRA.

Where am I going wrong here?

That type of scenario is a classic scenario where a Trad has an advantage over a Roth. But the story is not over until you begin withdrawing the money and manage to stay in the lower tax bracket. Managing the retirement tax bracket is critical to actually realizing the benefit you described.

As someone stated (one way or the other)... tax law could turn the table on you. But even of the bush rates sunset... that lower bracket is still lower than 25%... I think bottom two brackets are combined into 18%.

Even if the tax brackets remain the same for your anticipated income level, there are many situation that can cause you to wind up in a higher than expected tax bracket (e.g., RMD). You should developed a plan for how you intend to manage your retirement tax bracket now rather than waiting. This might give you time to position money in some way that is advantageous to the process.

Look at the Optimal Retirement Calculator and Retirement Decision Support System planner to better understand how to manage the distribution.
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Old 11-18-2010, 07:16 PM   #11
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more food for thought. assume tax rate = tax rate during drawdown. what's the difference between roth & traditional w/ investing the difference in taxable accounts? besides most people lack the discipline to "invest the rest."

i'm in the 25% tax rate now. assume i'll be a bracket down in retirement, where ever that may be (could be greater than 25%, could be less). the tax rate in the future is an uncertainty. i make sure to have a healthy mix of roth funds and traditional funds.
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Old 11-18-2010, 07:46 PM   #12
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What does all the blathering about a value added tax do to the planning ?
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Old 11-18-2010, 08:25 PM   #13
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I would assume a VAT would hit T-IRA and Roth equally, so hopefully a nuetral impact. T-IRA gets hit with income tax and then VAT, Roth skips income tax at withdrawal but still gets hit with the VAT. That also assumes the income tax stays in place rather than being replaced by the VAT.
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Old 11-18-2010, 09:03 PM   #14
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IThat also assumes the income tax stays in place rather than being replaced by the VAT.
That takes a real leap of faith. About the same leap needed to assume that the sun will come up tomorrow.

Ha
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Old 11-19-2010, 10:13 AM   #15
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The analysis here is correct.

I would like to emphasize 3 points

1) You need to qualify for the tax deduction on the traditional. If you do not qualify for this deduction, shift contribution (for that year) to a Roth contribution (if eligible). This is paperwork only, not tough to do.

2) Projecting tax rates is like trying to predict the superbowl champion in October. Good discussion, but pointless to the real outcome. Focus on these basics (as far as taxes):
a) paying some tax is good (means you have income), but paying lots of taxes is bad (it is inefficient)
b) some taxes will come out of traditional tax free. Someone pointed this out already, but it's worth reading again. Std deduction and exemptions take a person into 15% tax bracket without paying any tax in the 10% bracket.
c) my tax assumption is there will ALWAYS be brackets and ALWAYS be income ranges which are taxed at different rates (meaning flat tax won't happen). I am probably right . Just know where the brackets are and be mindful of what you are willing to pay now, vs defer until later. I am willing to pay 15% taxes now but not willing to pay 25% taxes now (meaning I do everything possible to get into 15% bracket, then I start using the Roth accounts in 401k and IRA).

3) It is OK to pay some taxes. The goal is highest after tax return. Focus on return after taxes.
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Old 11-19-2010, 12:37 PM   #16
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One other thing to consider is that the Roth beats the traditional IRA in terms of after-tax savings quantity. You can put the same amount into each, but the traditional IRA loses some to taxes when you take it out. In that one sense the Roth is better. The Fidelity IRA calculator shows that effect. If you are looking for a place to put funds that have already been taxed, the Roth is the place to be.
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