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Roth vs Regular IRA


jawn619
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I always thought that putting money in a Roth was more advantageous than putting it in an regular IRA, but after doing some calculations, I'm not sure if Roth is the clear winner

Example

 

Assumptions

25% tax rate

10% compound rate

 

Year one

Either put $10k in IRA or $7.5K in Roth

Year 10 Roth $69,849 IRA $93,132.26

 

After taking a 25% discount to the IRA, you end up with the same amount.

 

Other things to consider

Roth contributions can be taken out any time after 5 years. That's a huge benefit because of the flexibility

Regular IRA can be used be taken out tax free for certain events like buying a house/education expenses

 

Does anyone have anything else to add/pros/cons of each? It's not a clear cut decision but I'm still learning towards Roth.

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I havent done the math in detail for myself but at a basic level the argument for which one to go with is based on your current tax rate vs what you anticipate your retirment tax rate will be. I think it varies alot person to person but personally I am confident that my retirement income will have me in a much higher tax bracket than i am in now so i would rather pay the lower taxes now than later. In a few years I probably should dig into the numbers a bit more as that may have changed.

 

Also I think it depends on if getting the tax break from a traditional IRA helps your situation out.

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Time plays a big role too. The advantage of putting pre-tax dollars into a traditional IRA is magnified if you're expecting to withdraw from it in 20+ years. Also, if you've been compounding your pre-tax dollars for that long who knows what your situation will be and if your effective tax rate will still be 25%. The IRA gives you optionality in this situation whereas you take the tax hit on the Roth today. If your time horizon is shorter or tax rate likely to be higher then the Roth becomes more appealing.

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This has come up in the past, and Eric had some good comments on it.

 

One thing to note though, is that you put more effective money when you max out the Roth.  So, your calculations show you the same numbers assuming the same effective money.  For a Roth, you can actually put more money in than a Regular IRA.  More specifically:

 

Both the Roth and the Regular IRA have a $5,500 contribution limit.  These are not the same, however.  For a Regular IRA, that is $5,500 pre-tax.  But, for the Roth, the equivalent pretax number is $5,500 / (1-t).  So with a tax rate of 25%, that would be $7,333.  Thus, if you max out, the Roth is putting more money away than the Regular.

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One scenario to consider if you are young and make decent money (or just know of a time in the future where you won't make a lot of dough) is doing regular 401k and then roth conversion in a low income year (such as grad school or when starting a business or traveling or something).

 

a few of my friends have done regular while being single high income NYC finance or tech (no mortgage or wife to lower the tax rate) and then did or are planning on doing roth conversions in business school.

 

 

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Just a side note... I don't know if you are self employed or not...See if you can do a SEP-IRA...it has much higher contribution limits I think $53,000 for 2015...

 

yes I am but I am leaning towards solo 401k/solo roth 401k because the contribution limits are higher and you can loan yourself money

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For those with a lot of resources, the lack of an RMD on Roths is a significant factor. Build up a sizable Roth (if you don't need to take distributions to fund your retirement) that allows your beneficiaries to receive a tax-free "annuity" stream with withdrawals based on their life expectancies can be a neat estate planning option...especially for the beneficiaries.

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Both the Roth and the Regular IRA have a $5,500 contribution limit.  These are not the same, however.  For a Regular IRA, that is $5,500 pre-tax.  But, for the Roth, the equivalent pretax number is $5,500 / (1-t).  So with a tax rate of 25%, that would be $7,333.  Thus, if you max out, the Roth is putting more money away than the Regular.

 

That's the primary reason to go Roth.  The tax bill is settled.

 

The Regular IRA will compound at 10% annually -- so the tax liability will also compound at 10% annually. 

 

So think of the Roth IRA as letting you make a phantom contribution (the tax bill) that will compound at 10% annually.  The Regular IRA doesn't let you do that, so you have to somehow come up with after-tax 10% compounding for the monies that will eventually settle your tax bill, which is obviously much harder.

 

 

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For an apples to apples comparison -

 

Roth IRA final value:  (1-t)P [(1+r)^n]

That is you reduce your principal by current tax, and then compound that tax free at whatever rate for n years.

 

Regular IRA final value:  P [(1+r)^n](1-T)

That is your principal compounds by whatever rate for n years and then is taxed at whatever rate is available to you when you retire.

 

You'll notice that there is no difference between the two formulas except for what the values of t and T are. If you believe taxes (T) will be higher when you retire, it benefits you to put away (1-t)P today. If you think taxes (T) will be lower when you retire, you should put P away and pay the (1-T) rate later.

 

That keeps the comparison equal across both. As Eric and others have pointed out, if you're choosing to max out the contribution either way, then technically the $5,500 you can put into a Roth is quite a bit more than the $5,500 you can put into a regular IRA. This is actually how most people should look at it even though it's not an "equal" comparison, it's more likely to conform with how people save - by using the upward limit as the target and not some esoteric (1-t)P amount.

 

Diversification across the two does make sense as you get older, make more money, and move into higher tax brackets - you won't always make more in retirement than you're making currently and when it gets hard to decide you should be diversifying across both types of accounts. Now that I'm a few raises into my career, and live in a high tax jurisdiction (NYC), I have begun prioritizing maxing out my 401k before I contribute to my Roth that I have prioritized since I opened it in high school.

 

I like my Roth though - now that I've been contributed for nearly 10 years, I view it as a retirement account and an emergency account since there's quite of principal contributions that I could access in a pinch AND I can pull out principal and earnings for certain qualified purchases like my first house or certain medical expenses. If I don't ever need the money, it compounds tax free. If I do need the money, it's there for me. A regular IRA/401K can't really do either with anywhere near the same flexibility.

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Most people seem to be basing their decisions on the current law.  I'd suggest looking at the things the democrats have proposed on retirement accounts recently.  It wouldn't surprise me if a lot of the assumptions being made today turn out to be wrong.

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Most people seem to be basing their decisions on the current law.  I'd suggest looking at the things the democrats have proposed on retirement accounts recently.  It wouldn't surprise me if a lot of the assumptions being made today turn out to be wrong.

 

This is why I just stash money under my mattress.  Then I raid the mattress to pay cash for my chiropractor visits for a bad back. 

 

Have thought of transitioning to gold bars under the mattress, but early tests deem it too lumpy.

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Most people seem to be basing their decisions on the current law.  I'd suggest looking at the things the democrats have proposed on retirement accounts recently.  It wouldn't surprise me if a lot of the assumptions being made today turn out to be wrong.

 

This is why I just stash money under my mattress.  Then I raid the mattress to pay cash for my chiropractor visits for a bad back. 

 

Have thought of transitioning to gold bars under the mattress, but early tests deem it too lumpy.

 

You should try bitcoins. They protect you from robbery too - you just tie your mattress to a block chain.  8)

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Personally I think the last few comments are rather silly.  Everyone knows that you're supposed to keep your money in physical gold coins which you go swimming in each day, a la Scrooge McDuck.

 

On a more serious note, here is an example of what I am talking about:

 

http://www.marketwatch.com/story/president-obamas-2016-budget-targets-retirement-accounts-2015-02-05

 

Earlier Obama proposed putting a cap on the amount that would be allowed to be held in a tax deferred account.  It was based on the amount that would be required to fund an annuity paying around 200k IIRC.

 

I'm not sure if this changes anyone's mind but anyway it's probably worth taking into consideration.

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Something that no one has really talked about is your "expected rate of return".  If your expected 5-10 year runway is 20+% return (speaking hypothetically here), I think it becomes a no brainer to contribute into a Roth.  If you think you will compound at a high rate, you will wind up with a large sum when you are 59 years old.  Even at a lower tax rate, the absolute tax dollars can be quite high.  My feeling is that when I'm 59, my assets that generate income, Real Estate, securities, etc that throws off income will likely push me into a fairly high tax bracket anyway.  Assume you own $10mm of assets when you're 59 years old and the assets throw off 3% income (assume normalized interest rate), you're in a fairly high tax bracket already.  I think the Traditional Vs Roth argument applies more towards people who earn 6-7% rate of market equity return.  If you're generating returns that beat that threshold by a meaningful amount, it's probably best to go Roth, take the pain today, and not have to worry about taxes down the road.  Of course, the govt can change the tax rules and you can still get screwed, but I'll take that risk.

 

 

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Something that no one has really talked about is your "expected rate of return".  If your expected 5-10 year runway is 20+% return (speaking hypothetically here), I think it becomes a no brainer to contribute into a Roth.  If you think you will compound at a high rate, you will wind up with a large sum when you are 59 years old.  Even at a lower tax rate, the absolute tax dollars can be quite high.  My feeling is that when I'm 59, my assets that generate income, Real Estate, securities, etc that throws off income will likely push me into a fairly high tax bracket anyway.  Assume you own $10mm of assets when you're 59 years old and the assets throw off 3% income (assume normalized interest rate), you're in a fairly high tax bracket already.  I think the Traditional Vs Roth argument applies more towards people who earn 6-7% rate of market equity return.  If you're generating returns that beat that threshold by a meaningful amount, it's probably best to go Roth, take the pain today, and not have to worry about taxes down the road.  Of course, the govt can change the tax rules and you can still get screwed, but I'll take that risk.

 

If you re-read my post from the prior page, mathematically there is no difference between the two IRAs other than the differential in tax rates now and later. It doesn't matter what your return is.

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On a more serious note, here is an example of what I am talking about:

 

http://www.marketwatch.com/story/president-obamas-2016-budget-targets-retirement-accounts-2015-02-05

 

Earlier Obama proposed putting a cap on the amount that would be allowed to be held in a tax deferred account.  It was based on the amount that would be required to fund an annuity paying around 200k IIRC.

 

I'm not sure if this changes anyone's mind but anyway it's probably worth taking into consideration.

 

I agree. There is a likelihood that Roth will be re-legislated in next 10-20 years. I concur with people who suggest a mix.

 

OTOH though there are personal situations where one might be much better than other.

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