Monday, March 21, 2011

IRA's By the Numbers

In a previous article, I talked about some of the different types of common IRA's.  Here is a quick summary of the three common ones:


IRA TypeAre Contributions Taxes?Are Earnings Taxed?Are Withdrawals Taxable?Other Notes
Traditional, DeductibleNoNoYesIncome limits if in a retirement plan
Traditional, Non-deductibleYesNoOnly Earnings
RothYesNoNoIncome limits

As a follow-up, I thought I'd put together some numbers to show the differences between them for a couple of different scenarios.  I also added a fourth option for comparison:  a Health Savings Account.  If you remember from one of my previous articles, a Health Savings Account (HSA) allows you to contribute money tax free and withdraw it tax free.  The only catch is that you have to use withdrawn money to pay for a qualified health expense.  However, in retirement you can expect many opportunities to pay for those.

Scenario One:  25% tax bracket now.  33% tax bracket in retirement.

In this scenario, the tax rate that applies now is lower than your tax rate in retirement.  This situation is one that may be faced by a young, single person at the start of his or her career:

IRA TypeContributionContribution After TaxesBalance After 20 years @ 5%/yearBalance After Taxes
Traditional, Deductible$5,000.00 $5,000.00 $13,266.49 $8,888.55
Traditional, Non-deductible$5,000.00 $3,750.00 $9,949.87 $6,666.41
Roth$5,000.00 $3,750.00 $9,949.87 $9,949.87
Heath Savings Account$5,000.00 $5,000.00 $13,266.49 $13,266.49

As you can see, the Roth IRA comes out ahead of the other two flavors of IRA's.  As you would expect, since you are in a lower tax bracket now, it is better to pay taxes now rather than later.  The Traditional, Non-deductible IRA comes out on the bottom.  This is to be expected since you are paying taxes both on your contributions and your withdrawals.  Of course, the HSA comes out ahead of all of the IRA's since you don't pay taxes on contributions or withdrawals.

Scenario Two: 33% tax bracket now. 25% tax bracket in retirement.

This scenario is common to somebody who is at the height of their career.  The conventional wisdom is that your tax bracket will be lower in retirement than during your prime working years because you don't have to replace all of your income in retirement.  You may not have a mortgage, commuting expenses, the expense of raising kids, etc.  Obviously, this may not apply to everyone.

IRA TypeContributionContribution After TaxesBalance After 20 years @ 5%/yearBalance After Taxes
Traditional, Deductible$5,000.00 $5,000.00 $13,266.49 $9,949.87
Traditional, Non-deductible$5,000.00 $3,350.00 $8,888.55 $6,666.41
Roth$5,000.00 $3,350.00 $8,888.55 $8,888.55
Heath Savings Account$5,000.00 $5,000.00 $13,266.49 $13,266.49

In this case, it is better to pay taxes later than now, because you will be in a lower tax bracket later.  That is why the Traditional, Deductible IRA comes out ahead of its fellow IRA brethren. 

Scenario Three:  25% tax bracket now.  25% tax bracket in retirement.

This scenario shows what happens if you are in the same tax bracket now and in retirement.  This could be the case if you are planning to spend as much in retirement as you do when you are working.  Maybe instead of the expense of raising kids, you will use that money to travel more, eat out more, or just spend it on the grandkids.

IRA TypeContributionContribution After TaxesBalance After 20 years @ 5%/yearBalance After Taxes
Traditional, Deductible$5,000.00 $5,000.00 $13,266.49 $9,949.87
Traditional, Non-deductible$5,000.00 $3,750.00 $9,949.87 $7,462.40
Roth$5,000.00 $3,750.00 $9,949.87 $9,949.87
Heath Savings Account$5,000.00 $5,000.00 $13,266.49 $13,266.49

In this case, it doesn't matter whether or not you pay your taxes now or later - you will end up with the same amount of money in the end.  That is why the Roth and the Traditional, Deductible IRA's come out the same.

While it is possible to know how much taxes you are going to pay now, you may not know what your tax rate is going to be in retirement.  This is especially true if you are many years away from retirement.  There is one school of thought which says that taxes are bound to rise in the future in order to make good on the Federal debt.  One viable option is to diversify for taxes.  What do I mean by this?  I mean, you should put some money in a Roth IRA and some money in a Traditional, Deductible IRA (or a Traditional 401(k) if you can't contribute to a Traditional IRA).

Here is one possible diversification strategy:

- When you are just starting out in your career, put 100% of your retirement money in a Roth IRA.  When you are young, you are likely in the lowest tax bracket that you are going to be in for your entire life.  It makes sense to pay your taxes now at this lower rate rather than paying taxes later.

- As your career blossoms and your income rises, start to shift some of your contributions from a Roth IRA to a Traditional, Deductible IRA.  As you make more money, you will be in a higher tax bracket.  The chances of you being in a higher tax bracket in retirement start to decrease.  However, since you cannot know what Congress is going to do to the tax code, you play it safe by continuing to direct some of your contributions to a Roth IRA.

- As you moving to higher and higher tax brackets, you continue to direct a greater percentage of your retirement money into a Traditional, Deductible IRA.  You still keep some contributions directed into a Roth IRA just to hedge against higher taxes in the future.  However, at a certain point you may no longer be eligible to contribute to a Roth IRA directly.  In that case, you can contribute to a Traditional IRA and then convert some of that money to a Roth IRA.

Note that all of the above applies equally to a Traditional 401(k) and a Roth 401(k).

Of course, this strategy only takes into account maximizing your after tax income in retirement.  There are some other considerations when deciding which type of IRA to use:

- A Roth IRA allows you to withdraw the contribution portion of your account balance without a penalty.  However, withdrawals from a Traditional IRA prior to age 59 1/2 are subject to a 10% penalty on top of the taxes that you would pay normally.  This gives you some flexibility to access your money if you really REALLY need it.  Why would you want to do that, though?  It's supposed to be for retirement!

- A Traditional IRA requires that you make a mandatory minimum withdrawal (also know as the Required Minimum Distribution or RMD) starting at age 70 1/2.  This forces you to move your money out of a tax deferred account into a taxable account.  A Roth IRA does not have this limitation.  You can keep money in it as long as you want, allowing your earnings to compound tax free for as along as you want.

The decision of which type of IRA to use is a personal, individualized choice.  However, armed with the basic facts about the different types of IRA's work, you should be in a position to make an informed decision.

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