Traditional IRA vs. Roth

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boglestan
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Joined: Wed Mar 30, 2011 1:52 pm

Traditional IRA vs. Roth

Post by boglestan »

I feel like this topic must be beaten to death, but search results don't seem to yield any satisfying conclusion.

The best simple explanation I can nail down is that TIRA is better if your tax rate is higher right now, and Roth is better if your tax rate will be higher when you start withdrawing. Of course, how can a young person know what their tax bracket will be in 40 years?

Since it's probably too complicated to make a blanket statement for everyone, I'll give some of my specifics.

I'm 27, a software developer, and make mid-50K's right now. I suspect this will steadily increase over my career, but not dramatically. My wife works and makes 25-30K, with less promise of salary growth. She also will be taking at least a year off (probably a few) to raise a kid shortly.

When we retire, our cost of living should be below what it is now. I imagine we'll have fewer new shiny things to buy, no kid stuff to pay for anymore, less household space needed, etc. I don't dream of an extravagant retirement; just a secure one.

So how would I estimate what my tax bracket would be in 40 years? Are withdrawals from either type of IRA considered income? Is social security considered income? Will SS even exist? What else should I consider?
Last edited by boglestan on Mon Apr 04, 2011 11:30 pm, edited 1 time in total.
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Noobvestor
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Post by Noobvestor »

I like thinking about this problem from another angle: diversification. Much like I divide my assets between stocks and bonds, I try to divide them between Roth and tax-deferred options.

Moreover, Roths will forever be more limited for people making wages in the range you describe, so my theory goes: pack in what you can when you can, and don't worry too much about the unknowable distant future.

Having typed these generalizations, I'll defer to the more mathematically inclined to give you a specific numeric answer.
"In the absence of clarity, diversification is the only logical strategy" -= Larry Swedroe
Topic Author
boglestan
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Post by boglestan »

Noobvestor wrote:I like thinking about this problem from another angle: diversification. Much like I divide my assets between stocks and bonds, I try to divide them between Roth and tax-deferred options.

Moreover, Roths will forever be more limited for people making wages in the range you describe, so my theory goes: pack in what you can when you can, and don't worry too much about the unknowable distant future.

Having typed these generalizations, I'll defer to the more mathematically inclined to give you a specific numeric answer.
On an intuitive level, I really like this idea. It has the same seductive simplicity as the general Boglehead approach.
bdpb
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Post by bdpb »

It may be pretty hard to predict the future but at least look at the current
tax rates and where you stand. Most people (w/o pensions) will end up
in a lower bracket in retirement. If you're in the 28% or higher bracket, you
may well end up in the 25% bracket in retirement, so it will likely be a toss up
whether one is better than the other. If you are in the 25% bracket (which
I suspect you partially are) and unless you are saving a significant amount
then you will end up in a lower bracket. If tax rates stay the same, the
next lower bracket is 15%. I think the difference between 25% and 15%
is significant enough that I would lean towards tax deductible contributions
until my tax bracket was lowered to 15%. Then it's a toss up again whether
to continue deductible or Roth contributions. You could then choose Roth
for tax diversification.
Sachay
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Post by Sachay »

I'm confused as to how one would end up in a higher tax bracket at retirement- is it because you saved so much your disbursements are worth more than your final years' income?
bdpb
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Post by bdpb »

Sachay wrote:I'm confused as to how one would end up in a higher tax bracket at retirement- is it because you saved so much your disbursements are worth more than your final years' income?
A pension could put you very close.

You don't have to be in a higher bracket for Roth to be better. If you end
up in the same bracket and have contributed more than the tax deductible
max each year, then a Roth would be better because you won't have paid
annual taxes on the after tax account created from the tax deduction
savings.
Bob's not my name
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Re: Traditional IRA vs. Roth

Post by Bob's not my name »

boglestan wrote:My wife works and makes 25-30K, with less promise of salary growth. She also will be taking at least a year off (probably a few) to raise a kid shortly.
Don't know if you already turned these up in your search:

http://www.bogleheads.org/forum/viewtop ... highlight=

http://www.bogleheads.org/forum/viewtop ... sc&start=0

Does your wife have access to an employer plan?
JW-Retired
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Post by JW-Retired »

So how would I estimate what my tax bracket would be in 40 years? Are withdrawals from either type of IRA considered income? Is social security considered income? Will SS even exist? What else should I consider?
All TIRA retirement age withdrawels are taxable income treated like wages, you just deferred them. Well not exactly like wages since there is no FICA tax on them, you already paid it. ROTH IRA withdrawels are under the radar and not taxed at all. SS payments are taxed via a complicated sliding scale depending on your other income like from TIRAs (Roth withdrawels don't enter into it). If you have little other income then 0% of SS will be taxed, with a lot of other income 85% of SS will be. In between the amount jumps in steps and your effective marginal tax rate can be quite high.

A lot could change in the laws and rates in the next 40 years. Any time you are in the 15% bracket Roth would be an easy choice. That may happen when wife stops working. At 25% maybe not much difference.
JW
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bottlecap
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Post by bottlecap »

Here's my rule of thumb:

15% Bracket - Roth it
20% Bracket - Roth it if you expect your income to rise substantially over the years and you are a saver, otherwise, it's a toss up.
25% Bracket and up - TIRA it

You have to modify this for your personal situation. If you have a pension coming, will inherit substantial amounts in TIRAs, etc..., you might have a good idea that your income will be higher in retirement. If you are a medical resident, even a Roth at 25% or 28% might make sense (say you're pushed up due to spouse's income), because you are going to make a lot of money in the future and you are a saver.

JT
mptfan
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Post by mptfan »

bottlecap wrote:Here's my rule of thumb:

15% Bracket - Roth it
20% Bracket - Roth it if you expect your income to rise substantially over the years and you are a saver, otherwise, it's a toss up.
25% Bracket and up - TIRA it
That seems reasonable, except that there is no 20% bracket.
mptfan
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Post by mptfan »

Read the Bogleheads' Guide to Retirement Planning, Chapter 10.
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1210sda
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Post by 1210sda »

Another thing to consider.......when is your tax"break" more meaningful, now (TIRA) or later (roth) ??

1210
retiredjg
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Re: Traditional IRA vs. Roth

Post by retiredjg »

boglestan wrote:I feel like this topic must be beaten to death, but search results don't seem to yield any satisfying conclusion.
Even the discussions do not yield any satisfying conclusion.
When we retire, our cost of living should be below what it is now.

Cost of living can be ignored. The thing that counts is taxable income - pensions, money from a traditional 401k, money from an IRA that contains money that has not yet been taxed, some SS is taxable (depends on your other income). Money from a Roth IRA is not taxed under current law. Money you put in a taxable account is not taxed, but the earnings are.

As for your question, there are no hard and fast rules - people disagree on the theory and the math. Here's what seems sensible to me.

If you have a 401/403 - definitely use it at least up to the employer match (everyone agrees on that); then put some in Roth IRA; if possible max out the 401/403. The rub between factions here is generally in the last two steps I just listed - some people think the 401/403 should be maxed before putting any money in Roth IRA. I like the way I listed it because this will achieve some tax-diversification.

If you don't have a 401/403 - I'd use tIRA first to get at least some reduction in current taxable income. The exception would be if you are in a very low tax bracket and don't really need to lower your taxable income right now. In that case, Roth would be fine.
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og15F1
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Post by og15F1 »

I'd like to solicit some help deciding between a traditional and Roth IRA for the rest of 2011 and 2012 (and beyond). I'm switching companies and will not have a 401k available to me for some time ... I'd like to reduce my taxes if possible (obviously).

My wife and I are MFJ and she does not work. We will cross into the 25% bracket in 2011 but not by much. In 2012 we will be solidly in the 25% bracket.

1. If I was covered by an employer-sponsored retirement plan at Company 1, but will not be covered at Company 2 for the rest of 2011, will my deduction from a TIRA be subject to the income restrictions? I'm guessing yes

2. If I will not be covered by an employer-sponsored retirement plan at Company 2 until mid-2012, will my deduction from a TIRA be subject to the income restrictions in 2012? I'm guessing yes

3. I've seen this described as tax-deferred and tax-deductible. Does this mean that I contribute to the TIRA with after-tax money and then (potentially) take the deduction to get the "refund" on federal tax?

4. Does anyone have a good link to how MAGI is calculated? Specifically with respect to 401k contributions and employer provided healthcare. For 2011, I expect to be able to take the full deduction due to income - our MAGI should be less than 90k. For 2012, I expect to get only a partial deduction due to income - our MAGI will probably end up between 90k and 110k due to low healthcare premiums and the limit on how much I'll be able to put in the 401k.

5. Could I do a TIRA for my wife as well as myself in both 2011 and 2012? I've filled up about half of a Roth so far this year so I'm looking at putting the other $2500 in a TIRA for me and $5000 in a TIRA for her this year and then $5k each in 2012.


Overall I'm thinking this might make sense because my 401k contributions will be limited to around $10k/yr and there's a solid chance that there are only a few years left before we cannot get the TIRA deduction at all due to income. I don't foresee us crossing the income limits on a Roth for the foreseeable future.

Do you think TIRAs make sense in this situation?

Thanks
Johm221122
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Post by Johm221122 »

I always thought if portfolio was going to be less than 500,000 regular Ira better if more than this Roth better or combination
If you have pension,large interest or other income Roth best
Alan S.
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Location: Prescott, AZ

Post by Alan S. »

og15F1 wrote:I'd like to solicit some help deciding between a traditional and Roth IRA for the rest of 2011 and 2012 (and beyond). I'm switching companies and will not have a 401k available to me for some time ... I'd like to reduce my taxes if possible (obviously).

My wife and I are MFJ and she does not work. We will cross into the 25% bracket in 2011 but not by much. In 2012 we will be solidly in the 25% bracket.

1. If I was covered by an employer-sponsored retirement plan at Company 1, but will not be covered at Company 2 for the rest of 2011, will my deduction from a TIRA be subject to the income restrictions? I'm guessing yes

2. If I will not be covered by an employer-sponsored retirement plan at Company 2 until mid-2012, will my deduction from a TIRA be subject to the income restrictions in 2012? I'm guessing yes

3. I've seen this described as tax-deferred and tax-deductible. Does this mean that I contribute to the TIRA with after-tax money and then (potentially) take the deduction to get the "refund" on federal tax?

4. Does anyone have a good link to how MAGI is calculated? Specifically with respect to 401k contributions and employer provided healthcare. For 2011, I expect to be able to take the full deduction due to income - our MAGI should be less than 90k. For 2012, I expect to get only a partial deduction due to income - our MAGI will probably end up between 90k and 110k due to low healthcare premiums and the limit on how much I'll be able to put in the 401k.

5. Could I do a TIRA for my wife as well as myself in both 2011 and 2012? I've filled up about half of a Roth so far this year so I'm looking at putting the other $2500 in a TIRA for me and $5000 in a TIRA for her this year and then $5k each in 2012.


Overall I'm thinking this might make sense because my 401k contributions will be limited to around $10k/yr and there's a solid chance that there are only a few years left before we cannot get the TIRA deduction at all due to income. I don't foresee us crossing the income limits on a Roth for the foreseeable future.

Do you think TIRAs make sense in this situation?

Thanks
1) You are correct. If you are covered by an employer plan for even one day in the year, you are considered a participant all year.

2) Again, same as above

3) All retirement plans are tax deferred, meaning that gains and losses in the plan are not reportable and taxes are not due until distributions. The tax deduction for contributions is a separate issue and depends on the type of plan, and possibly your income or joint incomes.

4) It's in Pub 590, p 15.
http://www.irs.gov/pub/irs-pdf/p590.pdf
Your pre tax 401k contributions do not count and neither does the employer portion of your medical as well as pre tax medical insurance deductions or FSA accounts. The IRS will use the figure in Box 1 of your W-2 which excludes the above items, but does NOT exclude FICA and Medicare deductions. You must add any TIRA deduction back in to get your MAGI. If you fall in the phaseout range and qualify for a partial deduction, you can make the balance of your contribution to a Roth IRA, as you will be under the Roth income limit.

5) Yes, your wife qualifies for a spousal contribution using your earned income. For 2012, she also qualifies for a full deduction unless your joint MAGI exceeds 169,000.

Not enough info to tell regarding the balance between TIRA and Roth. You should probably stick with TIRA contributions while you can get the deduction, and then move to Roth contributions when you can no longer get the deduction and when your 401k and TIRA balances reach 100k or so, but that is a very general statement. Since you already have a Roth IRA, your 5 year clock has already started.

If you get caught in the phaseout range with too high a TIRA contribution, you should recharacterize the excess amount over to your Roth IRA rather than withdrawing it. Withdrawing in the phaseout triggers taxable income and a new phaseout like a chicken and egg scenario and it is a mess.
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archbish99
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Don't forget deductions....

Post by archbish99 »

This has been my logic:
  • If everything is in TIRAs or T401ks, then everything is taxable, and I likely will be in a higher or similar income bracket. In that case, I'll wish I had done a Roth.
  • If everything is in Roths, then nothing in taxable, I'll be in a very low income bracket, and I won't be able to take deductions for anything.
  • 401k matching is Traditional regardless of what my contribution is.
Based on that logic, I've settled on the following:
  • Roth 401k contributions up to the matching limit (match goes in T401k)
  • HSA contributions up to the limit in years we have that option (tax-free if used for healthcare, tax-deferred otherwise)
  • Roth IRA contributions
This way, we end up with a combination of both -- hopefully just enough for deductions to cancel out the taxable income from the 401k distributions. :) Of course, this is predicated on the fact that we donate substantial portions of our income and intend to donate similar portions of our retirement distributions as we take them. If you don't expect substantial deductions that you need to hedge taxable income against for maximum benefit, then all-Roth may be the way to go.
Alan S.
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Post by Alan S. »

That generally makes sense.

Over the long haul, big time savers should should increase their Roth allocations and big time spenders should stick with pre tax. If your spending is on tax deductible items such as charity or a big mortgage, all the more reason to favor pre tax contributions since the IRS will then participate in your spending up to your marginal tax rate.

Integration of an HSA can be useful because of the double tax free benefits, and the opportunity to only take distributions in strategic situations and not to take them in other situations for instance if you can itemize medical in a given year.

Since Roth balances are generally in lieu of pre tax balances and their eventual RMDs, they tend to replace higher tax bracket TIRA distributions first and therefore the first Roth balances are more valuable on a net after tax basis than later and higher Roth balances. Taxpayers should strive for that ideal mix of Roth and pre tax retirement account balances, with a bias toward the Roth if taxable balances grow, an inheritance is received etc.

People should try to identify their goals and spending needs first before focusing on tax changes and their retirement tax rate. The following are the largest deterents that degrade Roth savings at the expense of pre tax:
1) Poor savings habits and/or spending levels
2) Premature health problems
3) Lack of consistent employment income
4) Divorce and other adverse litigation
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mmmodem
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Post by mmmodem »

Noobvestor wrote:I like thinking about this problem from another angle: diversification. Much like I divide my assets between stocks and bonds, I try to divide them between Roth and tax-deferred options.

Moreover, Roths will forever be more limited for people making wages in the range you describe, so my theory goes: pack in what you can when you can, and don't worry too much about the unknowable distant future.
My rule of thumb is always go for the Roth no matter how much you make. (After employee match if you get it, of course) Taxes now or deferred can be argued every which way but without a crystal ball, it's all speculation. Why not look at things that are for certain? One thing for certain is that Roth's do not have RMD's and contributions can be taken out at anytime. Those two benefits right there tip the scale for me.

PS I know, it's only as certain as politicians don't change the tax code.
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