trapped in an IRA

[GrayHare]

Does anyone else feel trapped by their IRA? When IRAs blossomed in the 1980s I did like so many others and annually contributed the max. Though I knew pre-tax IRA funds would be taxed upon withdrawal, years elapsed before I learned those withdrawals would be taxed at ordinary income rates. For many who accumulate via LBYM, rate brackets will not be much lower after FIRE than before.

Had I instead put those contributions into, say, Exxon stock held outside the IRA, where dividends and capital gains are taxed less that ordinary income, I think it would now be worth more after tax than my IRA is. Even better than Exxon would be to buy and hold a growth stock that pays minimal dividends since its capital gains can be deferred indefinitely. Conclusion: unless after FIRE one's ordinary income rate will be less than dividend/CG rates, IRAs are a trap.

 

[kaneohe]

hmm, wonder if that's true. Has to be a numbers thing tho...

1) Case A...10K TIRA; assume 25% bracket and 2.5K side tax fund
After N yrs, TIRA doubles to 20K and side fund doubles to 5K;
To get aftertax value at the point ...liquidate both
TIRA becomes 15K and side fund is 5K less (at best) cap gains tax on 2.5K
so total is 20K less CG on 2.5K

2) Case B....10K in taxable; side fund used to pay tax on that income
After N yrs, taxable doubles to 20K. To get aftertax value, liquidate
and that becomes 20K less (at best) cap gains tax on 10K.

Seems like if math is correct (pls check) that case A is still better.
Of course, if the past several yrs tax law continues, you could benefit, perhaps from 0%15% LTCG/QDIV along the way for case B but who knows if that will continue.

 

[Animorph]

What kaneohe says, plus:

Your IRA withdrawals may have the benefit of a better average tax rate than your current marginal tax rate, if you don't have a lot of other income. Some of it comes out within the lower tax brackets. Plus, the growth within the IRA comes tax free even if the marginal tax rates for contributions and withdrawals are the same. It's the same % either going in or coming out, won't matter when you actually paid it. And you even get some inflation creep protection as the tax brackets are adjusted.


That said, I did contribute just enough to receive the company match and placed the rest in a taxable account. Until these last few years when I've been trying to stay in a lower tax bracket to pick up tuition tax credits and Roth contributions. Which I guess may be another benefit of maxing out.

 

[GrayHare]

Hmm, after trying some math, I see if all the IRA contribs are pre-tax then IRA does come out ahead. However, if half the IRA contribs are post-tax, as is roughly true for me and perhaps others, and ordinary rates are the same pre- and post-FIRE, then the numbers end about the same as the outside IRA investment:

1) If all IRA contribs are pre-tax, then all $100k goes into IRA. In 40 years it grows 4x to $400k. Full $400k is subject to 30% tax of $120k, leaving $280k after tax.

2) If half of IRA contribs are after tax dollars, IRA is funded with $50k pre-tax and $35k after-tax, $85k total. In 40 years it grows 4x to $340k. $305k is subject to 30% tax of $91.5k; $340k-$91.5k leaves $248.5k after tax.

3) Instead, keep same $100k outside IRA, pay the 30% tax, leaving $70k for a buy-and-hold stock investment. In 40 years it grows to $280k. Gain is $210k, pay 15% CG tax of $31.5k, leaving $248.5k after tax.

Since scenario #2 and #3 result in about the same, #3 is interesting since it has no RMDs. OK, so an IRA is not quite the trap I thought it was, but it's interesting to see a buy-and-hold approach like #3 can be competitive.

 

[james7]

Does anyone else feel trapped by their IRA? When IRAs blossomed in the 1980s I did like so many others and annually contributed the max. Though I knew pre-tax IRA funds would be taxed upon withdrawal, years elapsed before I learned those withdrawals would be taxed at ordinary income rates. For many who accumulate via LBYM, rate brackets will not be much lower after FIRE than before.

Had I instead put those contributions into, say, Exxon stock held outside the IRA, where dividends and capital gains are taxed less that ordinary income, I think it would now be worth more after tax than my IRA is. Even better than Exxon would be to buy and hold a growth stock that pays minimal dividends since its capital gains can be deferred indefinitely. Conclusion: unless after FIRE one's ordinary income rate will be less than dividend/CG rates, IRAs are a trap.

You are absolutely correct. I realized this back in 1980-1981 when everyone had gone gung-ho over IRAs and annuities before they read the fine print. Of course it helped that I was in the business of selling annuities. What helped me to realize what a trap taxable IRAs and annuities are is that my parents (frugal people who taught school all their lives and had their savings boosted by an inheritance from my grandfather) had just retired, but their tax brackets did not go down because their combined social security income, retirement pensions, and investment income were higher than in their working years. That is the reward the government gives us for being frugal. So, why invest in an IRA that defers taxes until you are in a higher tax bracket, and then forces you to pay taxes on the interest, dividend and capital gains income it produced at the highest possible rate?

As middle class Americans, the two biggest REAL tax breaks the government gives us are: 1) a much lower income tax on capital gains, and 2) the step-up basis for capital gains when one dies. Apparently the moral of the tax code is to buy stocks and real estate in your own name and hold them as long as possible, preferably until after you die.

The consolation in your case is that you have saved this money, not pissed it away like many others have done. That is something to be very grateful for, so continue to read widely so that you will not be caught in another government trap. I sure wish I had saved more!!

 

[MichaelB]

It is impossible to know in advance the math needed to make the most financially advantageous choice. At the time income was earned, minimizing tax had a high priority. Now, time to pay, that priority has been replaced by another.

There are other advantages to tax deferred accounts, as some investment only make sense when tax deferred, such as commodity funds and REITS. As one who had no tax deferred options, I see no trap, just the need to live with the choices made.

 

[Koolau]

As middle class Americans, the two biggest REAL tax breaks the government gives us are: 1) a much lower income tax on capital gains, and 2) the step-up basis for capital gains when one dies. Apparently the moral of the tax code is to buy stocks and real estate in your own name and hold them as long as possible, preferably until after you die.

I would add 3) The ROTH IRA. If I had it to do over, I would have placed much less in tIRAs and 401(k) and put more in taxable accounts instead. I would have maxed out my ROTH contributions as well. Now, in my dotage, I must carefully figure out which pot of money to pull funds from to keep my current AND future taxable income within manageable limits. I'm sure a case can be made for the benefits of tIRAs/401(k) but it isn't as simple as "put all you can into these vehicles". It ain't that simple for most of us. I look at these vehicles as overeating a favorite food. It sure tastes good going down, but...

 

[Sirka]

Does anyone else feel trapped by their IRA?

IRAs are a trap.

I don't feel trapped, I just live with the decision I made when I was in a high tax bracket. By putting some of the 'IRS' money into Stock Funds, I had a chance, over the early years, to learn about risk and loosing $$. IRA is IMHO a promise to IRS that you will pay tax on the money, that's left - if any!
We continue to convert to Roth by transferring the stocks, some times at a big discount (2009). So right now we can chose when to pay Uncle Sam...

 

[REWahoo]

What helped me to realize what a trap taxable IRAs and annuities are is that my parents (frugal people who taught school all their lives and had their savings boosted by an inheritance from my grandfather) had just retired, but their tax brackets did not go down because their retirement pensions and investment income were higher than in their working years.

I don't see any 'trap' here nor do I see any grounds for a complaint. Hard for me to find a problem with having a higher income in retirement than when I was working.

401k's converted to IRAs were our tickets to FIRE. We paid off the mortgage and live debt free to minimize our needed income and associated taxes. We've dropped to a lower bracket in retirement so it is working well for us.

As MichaelB said, you have to plan, manage and live with the choices made.

 

[Nords]

I don't see any 'trap' here nor do I see any grounds for a complaint. Hard for me to find a problem with having a higher income in retirement than when I was working.
As MichaelB said, you have to plan, manage and live with the choices made.

Aw, man, then it's no fun to complain about The Man and the IRS...

And congratulations on your 24,000th post! Can we get the moderators over here with the brass band and the gift cards?

 

[MichaelB]

And congratulations on your 24,000th post! Can we get the moderators over here with the brass band and the gift cards?

Are you just saying that to make sure that you get one as well?

 

[GrayHare]

If the TIRA contains after-tax contribs, at least Roth conversion provides something of an escape hatch.

As part of FIRE planning, this issue is worthy of attention by those still in the accumulation phase. Unless converted to Roth, after tax contribs to an IRA can be a losing proposition.

 

[easysurfer]

I don't feel trapped. On the otherhand, what if I had not contributed to an IRA and put the money in a company like "Enron"?

 

[nun]

I don't see the issue with the IRA as long as you understand it and organize your retirement income in a sensible way wrt taxation. In my case last year I paid 16% tax and in ER I expect that to go down to 10%. The big question is whether to do IRA to ROTH conversions to limit RMDs and the tax bill when they start.

 

[LOL!]

If one retires early with a large after-tax account and a large IRA, then they can live off the taxable account and pay virtually no taxes while converting the large IRA to a Roth IRA piecemeal without paying any taxes on it. That is, the contributions were tax-free and the conversions are tax-free as well. It is one of the biggest tax breaks out there and by no means a trap.

Now it is true that one probably should not have made after-tax contributions to an IRA in the old days. Nowadays, there may be a good reason to do so, namely the so-called 'backdoor' Roth IRA if one's income is too high to make straight contributions to a Roth IRA.

 

[Beryl]

No trapped feelings here. Nearly 50% of my net worth is in IRA accounts and I'm thankful that I was able defer the tax. I also plan to convert to ROTH accounts when it makes sense.

 

[ESRwannabe]

I feel very confident that my tax bracket will not be any lower in retirement than it is now. So, although I have always put in more than enough to get all of my employer's 401k match, I have never completely maxed out my 401k contributions. I have maxed out my Roth IRA every year.

I basically use my 401k to get the free match, and as a great place to allocate money to bonds. My 401k is entirely in the Vanguard Total Bond Market index. I don't really see a point in putting stocks into my 401k.

In my taxable account I am all stock funds, individual stocks, and cash. I like having the flexibility of my accounts versus what I can access in my 401k. I also like having access to the dividend income. I pretty much always re-invest the dividends and capital gains, but not always. The flexibility to do exactly what I want, whenever I want, with this money is worth paying 15% taxes on it.

Also, if you use "tax loss harvesting", which I do sometimes, then you can really cut down on the taxes. I have about a $20k tax loss leftover still from the downturn.

 

[kaneohe]

If the TIRA contains after-tax contribs, at least Roth conversion provides something of an escape hatch.

As part of FIRE planning, this issue is worthy of attention by those still in the accumulation phase. Unless converted to Roth, after tax contribs to an IRA can be a losing proposition.

agree w/ your last statement...the worst of both worlds...no deduction going in and ordinary rates coming out(for earnings). You might want model the Roth conversion w/ your 50-50 mix of deductible/non-ded.

Also you might want to model your non-deductible contribution(and Roth conversion) in two ways: 1) reduced as you did by the taxes (limited resources) and
2) the full amount not reduced by taxes with taxes paid by a side fund.("infinite" resources)
Not sure how it works out for the non-deductible contribution but for a regular Roth contribution (if you were eligible), the conclusions are different
for a partial contribtion (balance to taxes) and a full contribution (taxes paid by side fund because the Roth is "bigger" when you have other resources to pay the taxes.

 

[LOL!]

It might be interesting to have a poll to figure out how common non-deductible traditional IRA contributions are for folks on this forum.

I will say that I started an IRA with non-deductible contributions. At the time, there was no such thing as a Roth IRA and I was not eligible for any deductible IRA contribution. I only contributed for 4 years when IRA limits were low and the account has only quadrupled in size, so not a very big amount of money. Nevertheless, it will get converted to a Roth at the 0% tax rate along with the rest of my tax-deferred assets.

 

[Alan]

By the time we had decided to stay in the USA our income was already too high for deductible IRA's.

When we ER'ed a couple of years ago our tax rate was 13% lower than it had been so I converted my IRA to a ROTH.

DW also has a SEP-IRA plus a roll-over IRA from her old company that she left in 2004. As such she can't convert just the tIRA to a ROTH. We'll continue to do ROTH conversions each year to fill up the 15% tax bracket while we can.

 

[omni550]

DW also has a SEP-IRA plus a roll-over IRA from her old company that she left in 2004. As such she can't convert just the tIRA to a ROTH.

Alan,

I have this situation also. I'm not clear on how this impacts conversions to Roth. Would you be willing to explain, please?

omni

 

[kaneohe]

Alan,

I have this situation also. I'm not clear on how this impacts conversions to Roth. Would you be willing to explain, please?

omni

read this Conversion Consequences

I think that what Alan meant is that while you can physically convert specific parts, for tax purposes all of the TIRAs (including rollovers , regular contributory, and perhaps SEPs) are considered one single mixed up IRA and the tax consequences might be different from what you might intuitively think.

As an example if you had a non-deductible TIRA w/ 50K and a rollover IRA with deductible contributions of 50K, and you convert the non-deductible TIRA, you might think you would pay no taxes because you've already paid taxes on those contributions. However by the single pot theory, you are considered as having converted 25K of non-deductible contributions and 25K of deductible contributions so you will pay taxes on 25K.

 

[Alan]

Alan,

I have this situation also. I'm not clear on how this impacts conversions to Roth. Would you be willing to explain, please?

omni

When you convert to a ROTH, all of your IRA's are taken into account, you cannot target any particular IRA. When I retired I had most of my retirement savings in my 401(k) which are not included in the calculations. When I converted my IRA I only had to pay tax on the gains.

In DW's case she had 3 IRA's.

A tIRA made up of after tax contributions + gains

A SEP-IRA made up entirely of before tax contributions + gains

A Roll-over IRA from a previous employer 401k, made up of before tax contributions + gains.

I'll now make up some numbers to illustrate.

My tIRA had a cost basis of $40k + $10k gains, so taxes paid only on $10k of the $50k conversion.

DW's tIRA had a cost basis of $40k +$10k gains.

Her other 2 IRA's had a total of before tax money of $200k.

If DW were to convert her tIRA, the proportion of not-taxed money is 50/250 of the cost basis.

1/5 of $40k would not be taxed so she would pay taxes on $42k and the cost basis going forward would now be $32k.

I may have the math slightly wrong but you get the idea.

The year after I converted my tIRA I rolled over my 401k into a roll-over IRA so my cost basis going forward is 0.

 

[jdw_fire]

i fixed your example list (and added to it). see my comments in red below

Hmm, after trying some math, I see if all the IRA contribs are pre-tax then IRA does come out ahead. However, if half the IRA contribs are post-tax, as is roughly true for me and perhaps others, and ordinary rates are the same pre- and post-FIRE, then the numbers end about the same as the outside IRA investment:

1) If all IRA contribs are pre-tax, then all $100k goes into IRA. In 40 years it grows 4x to $400k. Full $400k is subject to 30% tax of $120k, leaving $280k after tax.

2) If half of IRA contribs are after tax dollars, IRA is funded with $50k pre-tax and $35k after-tax, $85k total. In 40 years it grows 4x to $340k. $305k is subject to 30% tax of $91.5k; $340k-$91.5k leaves $248.5k after tax.
2) should actually look like this: If half of IRA contribs are after tax dollars, TIRA is funded with the $50k pre-tax and Roth IRA funded with the $35k after-tax, $85k total. In 40 years both grow 4x. The TIRA grows to $200k, all of which is subject to 30% tax of $60k; $200k-$60k leaves $140k after tax from the TIRA. The Roth IRA will also have grown 4x to $140k, all of which is tax free. the total is $280k.

3) Instead, keep same $100k outside IRA, pay the 30% tax, leaving $70k for a buy-and-hold stock investment. In 40 years it grows to $280k. Gain is $210k, pay 15% CG tax of $31.5k, leaving $248.5k after tax.

4) Keep same $100k outside TIRA, pay the 30% tax, putting the $70k remainder in a Roth IRA. In 40 years it grows to $280k, all of which is tax free.

the following no longer applies because #2 and #3 dont result in about the same.
Since scenario #2 and #3 result in about the same, #3 is interesting since it has no RMDs. OK, so an IRA is not quite the trap I thought it was, but it's interesting to see a buy-and-hold approach like #3 can be competitive.

what is shown is that using (the appropriate) IRAs results is a higher after tax future amount.

however, if you have investment money outside IRAs after maximizing your contributions to your IRAs, there is an even better approach. for the sake of this example i am assuming that the $100k in IRA mentioned in 1) was the max possible "contribution" so therefore the max possible "contribution" in 4) can also be $100k so instead of paying the taxes out of the contribition you pay the taxes from other funds (i am adding about $42,857). now all the examples change but for simplicity i am only going to change 1), 3) and 4).

1) If all IRA contribs are pre-tax, then $100k goes into IRA and the $42,857 that stays out gets taxed at the 30% rate and becomes $30k. In 40 years it all grows 4x, the IRA to $400k and the $30k to $120k . The full $400k is subject to 30% tax ($120k), leaving $280k after tax from the IRA and $90k of the rest is subject to 15% CG tax ($13.5k) leaving $106.5k. this results in a total of $280k + $106.5k = $386.5k after tax.

3) Instead, keep same $142,857k outside IRA, pay the 30% tax, leaving $100k for a buy-and-hold stock investment. In 40 years it grows to $400k. Gain is $300k, pay 15% CG tax of $45k, leaving $355k after tax.

4) Keep same $142,857k outside TIRA, pay the 30% tax, putting the $100k remainder in a Roth IRA. In 40 years it grows to $400k, all of which is after tax.

so, the bottom line is, using the Roth IRA is better than using the TIRA which is better than using no IRA.


BTW, the value of the Roth IRA is seen similarly when converting TIRAs(401Ks) to a Roth IRA, provided funds outside the IRAs are used to pay the taxes due on conversion.

 

[Nords]

Are you just saying that to make sure that you get one as well?

For me it's never been about the rewards-- I couldn't stop if I wanted to...