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Retirement vehicles and tax brackets
Old 08-28-2008, 03:40 PM   #1
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Retirement vehicles and tax brackets

Does the tax bracket you'll be paying in have any impact on whether to stock your money in Roth or Traditional IRA accounts. I'll be able to start using a 401k next year (first check), so you can weigh in on the best options when that is considered too.

Info:
I make 60k, she makes 38k - both at new jobs.
We get profit sharing checks and 401k contributions.
No matching in 401k.
Own a condo.
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Old 08-28-2008, 03:47 PM   #2
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Traditional IRA accounts would be best if funded during the working years in a high(er) tax bracket and then withdrawn in retirement in a low(er) tax bracket.

The case for the Roth IRA is the opposite.

Since we don't really know future tax rates it is unknown
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Old 08-28-2008, 03:50 PM   #3
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I was hoping for more precise guidance than that. ie. we are currently in the 25% tax bracket, but down the road she'll be at home with a kid or two and brackets will widen and we should be in a lower bracket; therefore traditional now and roth later (if we still qualify and it is still available)
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Old 08-28-2008, 04:13 PM   #4
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If your tax bracket remains the same then the value of an invested dollar (adjusted for your taxes) in either a Roth or a traditional IRA is the same (between when you invest it and when you take it out). Note that in a ROTH the taxes are paid up front when you earn the money. In a traditional IRA the taxes are paid when you take the money out.

So for example if you are in a 25% tax bracket and put in $1000 into a traditional IRA, you could deduct that $1000 off your taxes and only have a real cost of $750. Well lets say you leave it in for a couple of decades and that $1000 (pre-tax) money has grown ten times to $10k. You take the money out and pay taxes and keep $7500 (after tax money). Now lets suppose that you had funded that Roth IRA with the equivalent cost to you of $750. That money then grows ten times to $7500 and you then take it out and have $7500 to spend. Can you see from this example how the traditional and Roth IRA give you the same returns considering the tax-adjusted doallrs that are put in and that are subsequently taken out. It is only when tax rates change that one or the other makes a difference.

One advantage of a ROTH is that since you are putting in after-tax money that vehicle allows you to put in more (after tax money) than the tax-discounted traditional IRA. (ie. $5000 in a traditiona IRA needs to be discounted by your tax bracket to maybe $3750). The ROTH IRA lets you put in the full $5000.

All things being equal, many people move into lower tax brackets after retirement. That may not always be the case for people that continue to work and save or for people that or that strike it big (inheritance, lottery, super big investment returns).

If you believe that you will be in a lower tax bracket when you pull the money out of the IRA then a traditional IRA is the way to go. If your bracket will be higher then a ROTH is the way to go. As posted above future tax brackets are unknown so you have to estimate (guess) what they will be.

There are also some trust issues in that you are trusting the government to keep the rules the same for decades to come. You can game the system now under the current rules. However if the rules change then who knows

There are also some differences between the two plans in terms of someone inheriting them. Also some differences in required distributions when you hit your 70's.

here is one (of many) available articles that discuss the choices.

http://www.investopedia.com/articles....asp?viewall=1
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Old 08-28-2008, 04:33 PM   #5
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It also depends what state that you retire in. For example, Pennsylvania does not have state/local income tax on retirement income (including IRA's and SS). In PA, the government want's their money "up front", and taxes you on total income when you are working.

In retirement, no tax is due on any gains that have accumulated over many years. It may seem a big deal at a quick glance, but you also have to consider other taxes (sales, real estate, etc.) to determine what your actual "total effective rate" is, in retirement.

- Ron
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Old 08-28-2008, 07:57 PM   #6
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Keep in mind that you contribute at your marginal tax rate but withdraw, typically, closer to your average tax rate. For instance, if your only income in retirement was an IRA, and you were withdrawing 98K per year (your current joint income), your tax rate for the whole 98K would probably only be around 17% (even though your marginal rate would be 25%).

This is a simplification, but I find that many miss this concept. Typically, even if you are in a somewhat higher tax bracket in retirement, you would have been better off contributing at somewhat lower tax rates while working.

Also, IRA income in retirement can often be tightly controlled to match the upper bounds of tax brackets.

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Old 08-28-2008, 08:01 PM   #7
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Quote:
Keep in mind that you contribute at your marginal tax rate but withdraw, typically, closer to your average tax rate. For instance, if your only income in retirement was an IRA, and you were withdrawing 98K per year (your current joint income), your tax rate for the whole 98K would probably only be around 17% (even though your marginal rate would be 25%).
That's a good point but perhaps a little too simplistic. Keep in mind though that any Social Security income will likely be included (to the tax mix) in pushing the average and the marginal rate higher. Ditto for any pension and other income.
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Old 08-28-2008, 08:07 PM   #8
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Originally Posted by MasterBlaster View Post
That's a good point but perhaps a little too simplistic. Keep in mind though that any Social Security income will likely be included (to the tax mix) in pushing the average and the marginal rate higher. Ditto for any pension and other income.
MB, yes I understand that but I find that people often don't consider the average vs. marginal tax issue. Also, you can organize your affairs for tax reasons. An example would be delaying SS until age 70 while you draw down your IRA in your 60s.

Personally, I believe in diversification of tax vehicles -- it is great to have a ROTH, traditional, etc. One can withdraw the IRA up to the top of the X% bracket, if more money needed could withdraw that out of the ROTH, etc.

I tightly control my taxable income in retirement according to current tax laws.

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Old 08-28-2008, 08:22 PM   #9
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I wish they had had Roth's a long time ago. I didn't get much chance to invest in them, due first to too much income, then retirement.

I always assumed/hoped that I would be in a high tax bracket when retired (read rich), and I also assume taxes won't be going down for the most part. Therefore, to me the best bet is the Roth. If I lose the bet on the taxes I'll consider it a win anyway. And for these purposes I'm using the government's definition of rich.

I'm trying to manage my tax bracket in retirement, but in a number of years I'm going to be forced to start withdrawing, and paying the to-be-determined tax rate on it. I'm going to do some conversions to Roths when I get a chance (2010), partially for estate management purposes, and partially for tax management purposes.

Just MHO.
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