Home     Forum     401k     401k Rollovers
    Register   Login   Members   Search   FAQs     Recent Posts    




Roth or pre-tax IRA/401K, etc?

Reply to topic
Money Talk > Retirement Planning

Author Thread
Wino
Senior Member


Cash: $ 113.80

Posts: 560
Joined: 03 Aug 2012
Location: Dubai
Roth or pre-tax IRA/401K, etc?  Reply with quote  

One of the least understood ways to invest is which of the retirement plans is better: Pre-tax or Post-tax investments?

To define the terms: a post-tax plan such as a Roth IRA has you invest money that you have already paid taxes on, but when you withdraw the money, you pay no tax.

Term definition 2: a pre-tax plan such as an employer 401K has you invest money that you have not paid taxes on, but when you withdraw the money, you pay taxes on the withdrawals.

The myth: "Well, when I retire, I'll have millions of dollars, so I should use the Roth IRA, as that way, I'll pay less taxes when I deposit the money, but save lots of taxes when I withdraw the money."

The fact: If you assume a constant amount of money to invest, then both plans work out equally to your advantage or not, depending on only ONE factor: your tax rate. Let me show you one example:

Let's say you have a tax rate of 25% and $1000 per month to invest. You are therefore investing either $1000 in a traditional pre-tax IRA, or $750 in a Roth IRA. Assuming twenty years at 10% growth, these figures work out as $759,386.84 in the 401K, and $569,526.63 in the Roth. Simple division shows that the Roth is EXACTLY 25% less than the 401K. If you pay a 25% tax rate in retirement, then the amount of money you can spend in both cases is exactly the same.

It doesn't matter what investment figures you use, nor does it matter which tax rates you use, as long as you use the same rates for both the Roth and 401K type of investments. What most advisers omit is the taxes paid at the front end. They'll show figures for $1000 per month invested in either type of account. If you have $1000 to invest in a Roth, then you should have $1333 to invest in a 401K. The ratio is dependent on your tax rate. I've used 25% for all of these examples. Basically, you should have more to invest in a 401K type of plan than you'll have in the Roth type of plan, because you will have the unpaid taxes to invest in the 401K that you won't have for the Roth.

What does all of the above mean? It means that if you think your tax rate is higher now than it will be when you retire, then the 401K type of plan is best for you. If you think that your tax rate will be higher after retirement than it is now, then the Roth IRA is the best plan for you.

Of course, real life is not as static as these models, but the basic premise remains the same: Your tax rate when investing versus your tax rate when withdrawing will be the determining factor of which type of plan is best for you.

Wino
Post Mon Jun 30, 2014 3:53 pm
 View user's profile Send private message
PapaGeek
Contributing Member


Cash: $ 8.80

Posts: 41
Joined: 17 Jul 2014
Location: Maryland
 Reply with quote  

I just joined the forums to ask almost the same question. My / our situation is slightly different. Iím already retired, and Iím doing this planning for my girlfriend who is 58 and will probably retire at age 62 or 63, 4 to 5 years, so the growth will not be as significant. Also, and I hate to be a Johnny come lately know it all, but your tax rates do not take the taxability of Social Security into account. Here is the situation that we are possibly facing.

Her tax rate now is 25%. At retirement her rate will probably be 15%, but the taxability of Social Security will probably push her into the 85% taxability bracket. In other words, the withdraw of $1,000 from her IRA will also make 85% or an additional $850 of her Social Security taxable income. So, the withdraw of $1,000 will raise her taxable income by $1,850 and at the 15% rate will increase her federal tax due by $277.50, in other words an effective tax rate of 27.5%. This of course gets even worse if you reach the 25% tax bracket where the 85% Social Security taxability rate increases your effective tax rate to 46.25%.

So, to ask the related question that I joined to ask: Is it better to invest her IRA money now in a Roth or standard IRA at her 25% tax bracket and then withdraw it 5 years later at the 27.5% effective tax rate? Is the hidden growth for a short period of time worth the slight increase in tax rate at withdraw time?

I hope you do not consider this hijacking your post. If so, have the admin delete it and contact me so I can post it again on my own. My thought was why have two parallel threads with nearly the same topic, also my input on the taxability issue is relevant to your original post.
Post Thu Jul 17, 2014 8:32 pm
 View user's profile Send private message
Wino
Senior Member


Cash: $ 113.80

Posts: 560
Joined: 03 Aug 2012
Location: Dubai
 Reply with quote  

I don't consider it hijacking. You are omitting the fact that if she were to transfer the money from a traditional IRA to a Roth IRA, she will have to pay taxes on the transfer at her current tax rate AFTER the addition of the IRA monies.

Due to the above, you'll lose at least 15% of the value of the IRA to change it over. Not knowing exact figures, I can't work out precise future values, but in general, converting an IRA to a Roth long after inception of the IRA is usually not a good idea.

I would suggest leaving the currently-invested money in a pre-tax account, but any money between now and then should probably be deposited in a Roth. Also, there is currently no required minimum distributions from a Roth, so she could conceivably leave the Roth money in the account longer, gaining more long-term after-tax gains.

Others on this forum may have differing opinions. I'd like to hear from them if they do. I'm still trying to get my head around my own retirement/Social Security/which investments when scenario, myself, though I'm still a good 10 to 15 years out.
Post Thu Jul 17, 2014 9:50 pm
 View user's profile Send private message
PapaGeek
Contributing Member


Cash: $ 8.80

Posts: 41
Joined: 17 Jul 2014
Location: Maryland
 Reply with quote  

Thanks Wino; that was my way of thinking also. Another issue we have is that, as it stands now, her estimated SS benefit plus pension are only going to make up 48% of what she will need as income, leaving 52% to come from her IRAís. At this point in her life I think that is relying on the market for too much. We found a really nice life time annuity and plan to transfer about half of her existing pre-tax IRA into the annuity. With a few other tweaks, this will reduce her year 1 dependence on the market to about 20%.

My sister was heavy in the market in 2008 and she and her husband are now working part time jobs in their 70ís to make up for their losses! No way I want us to fall into that same trap!

PS: what are you feelings about the effective tax rates I mentioned?
Post Thu Jul 17, 2014 11:59 pm
 View user's profile Send private message
Wino
Senior Member


Cash: $ 113.80

Posts: 560
Joined: 03 Aug 2012
Location: Dubai
 Reply with quote  

At $1875 per month, her annual income is $22500. Using the 2013 1040EZ, she can deduct $10000 from that, assuming she's single, has no dependents, and cannot be claimed as a dependent on someone else's return. Her tax then becomes $1448 on $12600, which is less than a 6.5% tax rate (1448/22500 = 0.064356).

Does that answer your question? More than likely, her actual useable income will be the same, whether she chooses Roth or traditional IRA, as her tax rate now is probably similar to what she will have when she retires.

I am NOT a fan of annuities. I don't know your particulars, but until she maxes out everything else, I would not be looking at an annuity.
Post Fri Jul 18, 2014 9:32 am
 View user's profile Send private message
PapaGeek
Contributing Member


Cash: $ 8.80

Posts: 41
Joined: 17 Jul 2014
Location: Maryland
 Reply with quote  

That is not what I was talking about with the tax rates. If you go to the website page: http://www.howtofixsocialsecurity.com/CASTER.htm, it explains ďthe humpĒ, the effective 46.25% tax rate in detail. The example uses the Turbo Tax TaxCaster online tax calculator to show a 65 year old individual with a $30,000 social security income who withdraws $32,000 from their IRA. When they change their IRA withdraw to $33,000, their taxable income increases by $1,850, not $1,000 and their tax due increases by $462 even though there marginal tax rate remains at 25%. 25% of the extra $1,000 should have increased their tax due by $250, not $462! Their actual tax rate was 46.25%.

Most people ignore this extra tax rate increase because it is hidden from plain view by the tax code. They tell you about the 10%, 15% and 25% tax rates, then in a separate part of the tax regulations tell you about the taxability of your social security benefit at 50% and 85%. What people ignore is that taking additional money out of your IRA increases the ďbasisĒ used for the taxability of your social security by the amount withdrawn, so your taxable income increases by the extra amount withdrawn "plus" the additional social security benefit that has become taxable.

As far as the annuity goes, I am not a total fan either, but when it comes to retirement, you have to look at your income as two categories: your secure basis & market dependent. Without the annuity her market dependent percentage would start off at over 50%. If not an annuity, how else would you protect your retirement income for the devastation of a 10% or 20% market correction? Right now most of the baby-boomers are still putting cash into their 401Kís and buying market shares. Within 10 years or so, almost all of them will be taking money out of their 401Kís and selling market shares. If the market does respond with a major correction they will have to sell even more shares to keep up their income streams. I realize this is gloom and doom theory, but when you no longer have a source of income, you have to prepare for that. If it doesnít happen, your children will just inherit more! Or, you can spend their inheritance on nicer vacations!
Post Fri Jul 18, 2014 11:22 am
 View user's profile Send private message
MrNewEngland
Full Member


Cash: $ 20.45

Posts: 96
Joined: 04 Nov 2009
Location: The QC
 Reply with quote  

The other thing to consider that recently dawned on me is that if you plan to move to Florida or a state with no income tax in retirement and you're contributing to a Roth you are paying the state taxes when you don't need to.
Post Fri Jul 18, 2014 3:17 pm
 View user's profile Send private message
PapaGeek
Contributing Member


Cash: $ 8.80

Posts: 41
Joined: 17 Jul 2014
Location: Maryland
 Reply with quote  

If you really want to get sick over the taxation, start with the previous example. Your total Social Security is $30,000. You are taking $32,000 out of your IRA over the course of the year and making estimated withholding for state and federal taxes. Iím from Maryland, so state and local tax equals 7.55%. It is the end of the year, X-mas time, and you see a great gift for your someone special that will cost you an extra $1,000 that you didnít plan for.

Question: How much do you have to withdraw from your IRA to get $1,000 after tax for the gift?

Answer: Would you believe $2,164.50? You pay and extra $1,001.08 in federal tax plus $163.42 in Maryland tax, leaving you with $1,000 after tax!
Post Fri Jul 18, 2014 3:33 pm
 View user's profile Send private message
Wino
Senior Member


Cash: $ 113.80

Posts: 560
Joined: 03 Aug 2012
Location: Dubai
 Reply with quote  

That's not how it works. You are not taxed AT 85%. 85% of your Social Security, assuming you make OVER $34K in distributions. So, using your examples, if you make $24K in Social Security, and withdraw $24K, you'll have $36K in combined income.

As you are now over the combined income limit for a single person. you'll pay taxes on 50% of the $24K, at your current tax rate. After you do the taxes, you'll find that your current tax rate is about 15% (I won't adjust for the under $9K-ish amount; nor will I do any deductions to make the example clearer). So, for your tax purposes, your agi will be $36K (minus deductions). You aren't paying $12K in taxes. You're paying taxes on $12K of your social security.

This says that if you have substantial non-Roth retirement income, then you should delay social security.

THAT was not part of the original post, though. The original post dealt solely with the misconception that pre-Tax IRA's will get you less money to spend than post-Tax Roth IRA's.
Post Sat Jul 19, 2014 1:34 am
 View user's profile Send private message
littleroc02us
Moderator


Cash: $ 381.25

Posts: 1876
Joined: 09 Feb 2009

 Reply with quote  

Wino, those are some good basic explanation of the two different types of investments for retirement, but one thing you left out is fees. For example my 401k at work has in the neighborhood of around 2-3% fees which eat into the actual investment, whereas my Roth IRA's such as VTSMX has an expense ratio of only .17%. Those fees from my University of Minnesota 401k account will eat heavily into my retirement investment, especially since I've already worked here for 10 years and plan on staying for a long time. So, it can be difficult to compare the two investment strategies.
I tend to favor the Pre-tax investments now, because you never know what types of laws our wonderful government will put into place when it's time for those 401k's to be taxed at the time of withdrawl.

Risk comes from not knowing what you're doing. (Warren Buffet)
Post Mon Jul 21, 2014 2:25 pm
 View user's profile Send private message
Wino
Senior Member


Cash: $ 113.80

Posts: 560
Joined: 03 Aug 2012
Location: Dubai
 Reply with quote  

The thing is, though, that many 401K plans can be converted to IRAs when you leave, so which stocks/funds you pick should have the same fees.

I guess you should go back and prepend "all other things being equal" to my original post.

As you no doubt realize, the point is that the Roth or the pre-tax investment is neither of them inherently superior. It depends on one's personal situation.
Post Tue Jul 22, 2014 10:43 am
 View user's profile Send private message
littleroc02us
Moderator


Cash: $ 381.25

Posts: 1876
Joined: 09 Feb 2009

 Reply with quote  

I guess I just prefer the low fee investment that Vanguard offers and no taxes at the time of with drawl. What I like about my 401k is that my employer matches my contribution @ 5.75%. So it's a win win IMO.

Risk comes from not knowing what you're doing. (Warren Buffet)
Post Tue Jul 22, 2014 1:24 pm
 View user's profile Send private message

Reply to topic
Forum Jump:
Jump to:  
  Display posts from previous:      





Money Talk © 2003-2016