Interesting CPA comment on IRA/Roth IRA

[StageLeft]

I think your CPA isn't the smartedest. There are times when it sucks, but tell me how it would suck for a person investing while they make $40k/year now and expect to start making $500k/year later. Pay minimal taxes on it now and later it grows like a weed, oblivious to your high tax bracket.

My biggest problem is if in the future govt decides to tax Roth IRA as well.

That would suck and seems very underhanded to me. We've already paid money into it and it wouldn't be cool to tax again.

Most people wouldn't care, since most people have no real retirement savings (they're too dumb to realize they are probably going to be seniors one day), but on the other hand the lobbiests and all that are richer people and people more likely to have a roth, so hopefully the gov't won't try it

 

[Bryophyte]

Roth IRAs make a tremendous amount of sense for people during the years that they are making very little money, when they don't need a tax deduction because they aren't really paying very much in taxes, if anything at all.

Go do some reading on the Motley Fool's site (www.fool.com).

 

[DrPizza]

Originally posted by: Jzero

Originally posted by: dderidex

Originally posted by: Jzero
With Roth do you pay tax on the interest when you withdraw at retirement?

No, Roth IRAs are post-tax. You pay from them strictly out of your 'take home pay', so the money has already been taxed. When you withdraw from them, you pay no additional tax.

That's what I thought, but the original post made me second guess.

So given a choice between:
Putting in contributions in "present-day" dollars being assessed present-day tax rates and at retirement withdrawing your "present-day" dollars PLUS your tax-free interest in "future" dollars.

Or

Putting in contributions in "present-day" dollars and then at retirement withdrawing those "present-day" dollars plus your interest in "future" dollars and then having the whole thing taxed at future rates.

It seems like the first option will net you the larger gains and less tax costs if for no other reason than it saves your from paying ANY tax on all that compound interest that's been accruing for 40 years.

Actually, if the tax rate doesn't change, it makes no difference. Either is equivalent.

Let's say we're talking about X dollars, and an interest rate of R%, and a tax rate of T% for Y years.

Taxed up front, you have [1 - T/100]*[X]*[(1 + R/100)^Y]
Taxed at the end, you have [X]*[(1 + R/100)^Y]*[1 - T/100]
Commutative property of multiplication... they're the same.

example, with numbers:
25% tax rate, 10,000 dollars, 10% interest, 40 years.
Taxed before
.75(10,000) = 7500 invested. 7500*1.10^40 = 339444.42
Taxed after: 10,000*1.10^40 = 452,592. But, 75% of this (after deducting 25% for taxes) is still 339444.42.

 

[DrPizza]

Note: in my above example, I showed that if the tax rate is the SAME, then it doesn't matter.

So, if you expect to be in a lower tax bracket when you retire, have it taxed later.
If you expect to be in a higher tax bracket when you retire, have it taxed now.

 

[NogginBoink]

Originally posted by: mwtgg
I'd rather pay taxes at the current rate, who knows what they'll be when I retire. Then again, they could be very low, nonexistant, or exorbitantly high.

This is the argument that sways me. Given government's penchant for spending, and an aging population, I expect future tax rates to be higher than current tax rates. Thus I invest in a Roth IRA and pay taxes at today's known tax rate.

 

[edro]

What tax bracket should I be in when I retire?

I am young and don't make as much money now as I will when I am older... so does that mean I will be in a higher tax bracket then? Or because I will be retiring and thus having no income, I will be in a low tax bracket?

 

[DaveSimmons]

Originally posted by: DrPizza
Note: in my above example, I showed that if the tax rate is the SAME, then it doesn't matter.

So, if you expect to be in a lower tax bracket when you retire, have it taxed later.
If you expect to be in a higher tax bracket when you retire, have it taxed now.

This does assume that you have the choice between the two IRAs, but if you have a 401k then the trad IRA is no longer an option because it isn't deductible.

So if your employer has a 401k, the rule of thumb already stated above applies:
1. contribute to 401k up to employer match
2. then max out Roth IRA
3. then max out 401k
all while keeping a $0 balance on your credit cards.

 

[squeeg22]

Originally posted by: DaveSimmons

Originally posted by: DrPizza
Note: in my above example, I showed that if the tax rate is the SAME, then it doesn't matter.

So, if you expect to be in a lower tax bracket when you retire, have it taxed later.
If you expect to be in a higher tax bracket when you retire, have it taxed now.

This does assume that you have the choice between the two IRAs, but if you have a 401k then the trad IRA is no longer an option because it isn't deductible.

So if your employer has a 401k, the rule of thumb already stated above applies:
1. contribute to 401k up to employer match
2. then max out Roth IRA
3. then max out 401k
all while keeping a $0 balance on your credit cards.

As I posted earlier: What if your company doesn't match (gives employee stock instead)? Should I still max out 401k and then put into a Roth? Or other way around?

 

[alrocky]

Originally posted by: rufruf44
My biggest problem is if in the future govt decides to tax Roth IRA as well. There's already grumbling about it and with the current deficit all over the place, it'll be hard for bureaucracy to ignore another source of income.

It's fairly pointless to base your decision on whether or not to invest in a ROTH IRA because of something that may or may not happen in the future. Don't think your SS example is a fair comparison anyway since the ROTH IRA was created (as a distinction from a traditional IRA) with the tax free benefit at time of withdrawal. IF there is a change, I'd think the present ROTH IRA accounts would be grandfathered in as presently constituted.

With Roth do you pay tax on the interest when you withdraw at retirement?

No. Paying no tax at withdrawal is the reason you get a ROTH IRA. This is it's selling point.

Generally speaking you should max out your company's retirement plan and max out your IRA every year before most other investment vehicles. Whether you select a ROTH or a traditional IRA can be a little more complicated. The younger you are when you start investing in an IRA, the more likely a ROTH may be better for you in the long run. If you presently make "too much money", you won't be able to deduct the entire $4000 investment in a traditional IRA this year (this happened to a coworker so the IRS may send him a letter.) You pay taxes on a traditional IRA at time of withdrawal but not for a ROTH -- More simplicity and no headaches worrying about tax implications for a ROTH IRA.

The "magic" of long term investing is the power of compounding: the amount you actually invest is only a small portion of what your money is worth at retirement. Looking at the linked chart, you can pre-pay tax on the invested portion in a ROTH or pay taxes on the whole amount in a traditional IRA.

There are two things noone ever says at retirement:
1) I shouldn't stayed longer at the office.
2) I invested too much money for retirement.

---
[EDIT] I suck at linking:https://flagship2.vanguard.com/VGApp/hnw/HomepageOverview
Click Take it to the limit with your IRA contribution

 

[IHateMyJob2004]

Originally posted by: spidey07
From a retirement perspective he says "why in the world would you do retirement investing with post-tax dollars? Roth IRAs are fine if you intend to take the money out before you retire, but for retirement its not a good idea.

"Your dollar today is worth more than it is tomorrow due to inflation"

Kinda makes sense.

Depending on your age, Traditional IRAs are better than Roth's.

 

[IHateMyJob2004]

Originally posted by: spidey07

Originally posted by: gopunk
because the gain is not taxed?

your doller today is only worth more if you can't outpace inflation with some type of investment.

there has to be a calculator out there somewhere to compare the two. Another point he made is "always defer taxes"

key word, ALWAYS. Fire his a$$

 

[IHateMyJob2004]

Oh, one last thing... time for bed.

Do not do a 401 K, traditional IRA or Roth-IRA. In my case anyways, I can retire at 45 easily. Using retirment accounts just ties your money up, forcign you to wait till you are dead to retire (age 55+ anyways)..

To each there own. But if you can invest $20K a year in a normal stock account instead of $10K in normal account and $10K in retirement accounts, you don
t have to wait till you are 59. Get out your Excel programs and start making some spreadsheets! It's easy to do!

 

[DaveSimmons]

Originally posted by: IHateMyJob2004
Oh, one last thing... time for bed.

Do not do a 401 K, traditional IRA or Roth-IRA. In my case anyways, I can retire at 45 easily. Using retirment accounts just ties your money up, forcign you to wait till you are dead to retire (age 55+ anyways)..

To each there own. But if you can invest $20K a year in a normal stock account instead of $10K in normal account and $10K in retirement accounts, you dont have to wait till you are 59. Get out your Excel programs and start making some spreadsheets! It's easy to do!

That makes some sense for the tiny fraction of people here who can invest over $20K a year every year (especially if they plan to die before age 60), but it's still bad advice for most of them on skipping the Roth. The Roth IRA lets you take out your principal if you manage to retire early, you only have to leave in the compounded growth.

You pay taxes every year on capital gains and dividends when you have a normal, unsheltered brokerage account, you don't have to pay this with your Roth. So even when you retire at 45 the Roth is a good place to keep a chunk of your investments.

For those planning to live beyond 60, skipping a 401k with employer match is also a bad idea.

 

[wyvrn]

An interesting article to throw in here, discussing future taxing of social security benefits as a wrinkle to the argument:

More in a 401(k) could add up to less

Tax rate, plan's cost and employer match need to be in equation

08:47 PM CDT on Wednesday, May 18, 2005

By SCOTT BURNS / The Dallas Morning News

Question: Assuming you take advantage of all of your employer's retirement benefits, are there circumstances under which it would be advisable to take your salary today and invest a post-tax portion in taxable funds rather than place the pre-tax amount in a 401(k)?

I am working in a state that has no income tax but wish to retire to one that does. It would seem that, in some cases, it might be better to pay now and take advantage of lower taxes.

D.R., San Antonio

Answer: That's a very important question. It's a question that will be getting more and more attention in the future as retirees start to realize how the taxation of Social Security benefits impacts their retirement savings.

There are three major factors to consider when deciding where to invest your retirement savings:

?The employer match, if any.

?The cost of the employer's plan compared to alternatives.

?Your anticipated future tax rate.

When your employer matches 50 percent or 100 percent of your contribution, there is every reason to participate fully. If you don't, you are walking away from free money. Even when the match is in company shares, it is still beneficial to "capture the match."

If your employer provides no matching funds, the decision is more complicated because you have to weigh the convenience, ease and higher limits of a 401(k) or 403(b) plan over alternatives you can find on your own. Most public school teachers, for instance, could do far better than the investment options they are offered through their 403(b) plans because most teacher plans are loaded with variable annuity products that have annual expenses greater than 2 percent a year. If they will do their own homework, they can invest independently and have annual expenses of less than 0.2 percent a year.

The current limit on 401(k) and 403(b) plan contributions is $14,000, plus an additional $4,000 for those age 50 and over. IRA plans are limited to $4,000 plus an additional $500 for people age 50 and over. For many workers, the $10,000-plus difference doesn't matter ? saving $4,000 a year is difficult enough. An average worker, for instance, earns about $35,000 a year, so $4,000 a year would be 11.4 percent of gross income, a hefty amount.

Rather have a Roth?

Given a choice, many younger workers should opt for a low-cost Roth IRA plan over an unmatched employer plan. Since a Roth IRA has the same contribution limit as a traditional IRA but is funded with after-tax money, the effective contribution limit is higher.

If you are in the 25 percent tax bracket, for instance, the $4,000 you contribute to an IRA will be subject to taxation in the future. To contribute $4,000 to a Roth IRA, you will need to have paid taxes on $5,333 of income but will have no taxes to pay in the future.

Most people assume they will pay income taxes at a lower rate when they are retired than when they are working. This may not be true for those planning to move from a no-tax state to a state with an income tax. It may also not be true if you are a middle-income worker whose qualified plan withdrawals will trigger the taxation of Social Security benefits.

Suppose you are in the 15 percent tax bracket while working. If you put your money in a traditional IRA, all later withdrawals will be taxable. If they trigger the taxation of Social Security benefits, your effective tax rate on withdrawals will be 22.5 percent.

You would be better off paying the 15 percent tax today and putting the same money in a Roth IRA. Since withdrawals from Roth IRAs aren't taxable, the taxation of Social Security benefits won't be triggered and you'll pay no taxes at all.

So it's 15 percent now or 22.5 percent later.

Because the formula for the taxation of Social Security benefits isn't indexed to inflation, workers in their 30s and 40s should favor Roth IRAs over traditional IRAs. (An earlier column that demonstrates this is available on my Web site, www.scottburns.com.)

After-tax talk

And what if you just put the after-tax money in a taxable account?

That won't be particularly beneficial if you are in the 15 percent tax bracket (taxable income in 2005 of $14,600 to $59,400 on a joint return), but it is likely to be beneficial if you are in the 25 percent tax bracket and receive your future income in dividends and capital gains.

Why?

Because if you save tax-deferred, all withdrawals will be taxed as ordinary income, probably at 25 percent. In addition, they will probably trigger the taxation of Social Security benefits, increasing the effective tax rate to 37.5 percent or 46.25 percent. Take the income from a taxable account as dividends and capital gains taxed at 15 percent, however, and you may trigger Social Security benefit taxation, increasing your effective tax rate to 22.5 percent to 36.25 percent. Either way, it's a big difference.

Bottom line: For young workers, saving a few tax dollars today can be "penny wise and pound foolish."

Scott Burns answers questions of general interest in his Thursday columns. Write Scott Burns, The Dallas Morning News, P.O. Box 655237, Dallas, Texas 75265, or send an e-mail.

E-mail sburns@dallasnews.com