Roth IRA vs Traditional

[joec]

I’ve reviewed this question many times myself in the past and have changed my view on this a while back. I used to be in the camp of 100% Roth because the goverment can only raise your taxes, but take a look at this article and some the other links in the article and you might rethink your view. I know I have. Also, a key point which is very true is job changes / layoffs, etc where you can choose at anytime when you want to do an IRA conversion to a Roth and pay low or no tax. Another good point is all the tax credits for lower income folks or middle income folks. Like the new home buyer credit, you can’t get if your income is too high.

Also, if you ever start a business, you can be looking at low taxes for a few years and do conversions every year to use up your business losses, exemptions, deductions, etc…

Unlike our parents, 30 years at the same company with a pension is very unlikely and for the overall flexibility and not being “forced” to pay taxes now, I think a regular 401k or traditional makes a lot of sense.

For people without a stable pension paying you 50 or 100k, your IRAs/401ks will probably be your only income next to social security so (check the links), you would need a pretty massive IRA before you will be in a higher tax bracket than the minimum tax rates.

http://thefinancebuff.com/2008/03/case-against-roth-401k.html

[an]

joec, those theories sound really good, so I decide to calculate it out to see if it really make that much sense. Lets assume you have nothing right now and you put $15k each year for the next 5, that’s a total of $75k. Lets also assume you’re in the 25% tax bracket, CA tax is 10%, and you make average 8% a year (obviously this can change wildly depending on your investment strategy and market condition). If you go with ROTH, you pay a total of $26250 in taxes. If you go with Traditional and 5 years from now, you got laid off in January 1st and won’t be able to find another job for a whole year (no additional income that year). With 8% compound interest, your $75k should grow to about $92225. If you convert the whole amount that year, you’re in the 25% federal and 10% tax bracket. Your total tax liability is $32278.75. If you’re unemployed for less than a year, you’d have to add that income into the traditional calculation. If the market crash and you convert at less than $75k, then traditional would be a better bet. If the market grew at more than 8%, you’d have to pay that much more in taxes. So, it’s not as black and white as that article make it out to be. That’s just assume 5 years as well. The longer you’re employed, the more advantageous ROTH becomes, due to the tax free growth. Lets assume all the above variables stay the same and you won’t be out of work until 10 years from now. Roth, your total tax liability is $52500. Traditional, your total tax liability is $80430.95.

[an]

joec, those theories sound really good, so I decide to calculate it out to see if it really make that much sense. Lets assume you have nothing right now and you put $15k each year for the next 5, that’s a total of $75k. Lets also assume you’re in the 25% tax bracket, CA tax is 10%, and you make average 8% a year (obviously this can change wildly depending on your investment strategy and market condition). If you go with ROTH, you pay a total of $26250 in taxes. If you go with Traditional and 5 years from now, you got laid off in January 1st and won’t be able to find another job for a whole year (no additional income that year). With 8% compound interest, your $75k should grow to about $92225. If you convert the whole amount that year, you’re in the 25% federal and 10% tax bracket. Your total tax liability is $32278.75. If you’re unemployed for less than a year, you’d have to add that income into the traditional calculation. If the market crash and you convert at less than $75k, then traditional would be a better bet. If the market grew at more than 8%, you’d have to pay that much more in taxes. So, it’s not as black and white as that article make it out to be. That’s just assume 5 years as well. The longer you’re employed, the more advantageous ROTH becomes, due to the tax free growth. Lets assume all the above variables stay the same and you won’t be out of work until 10 years from now. Roth, your total tax liability is $52500. Traditional, your total tax liability is $80430.95.

[an]

joec, those theories sound really good, so I decide to calculate it out to see if it really make that much sense. Lets assume you have nothing right now and you put $15k each year for the next 5, that’s a total of $75k. Lets also assume you’re in the 25% tax bracket, CA tax is 10%, and you make average 8% a year (obviously this can change wildly depending on your investment strategy and market condition). If you go with ROTH, you pay a total of $26250 in taxes. If you go with Traditional and 5 years from now, you got laid off in January 1st and won’t be able to find another job for a whole year (no additional income that year). With 8% compound interest, your $75k should grow to about $92225. If you convert the whole amount that year, you’re in the 25% federal and 10% tax bracket. Your total tax liability is $32278.75. If you’re unemployed for less than a year, you’d have to add that income into the traditional calculation. If the market crash and you convert at less than $75k, then traditional would be a better bet. If the market grew at more than 8%, you’d have to pay that much more in taxes. So, it’s not as black and white as that article make it out to be. That’s just assume 5 years as well. The longer you’re employed, the more advantageous ROTH becomes, due to the tax free growth. Lets assume all the above variables stay the same and you won’t be out of work until 10 years from now. Roth, your total tax liability is $52500. Traditional, your total tax liability is $80430.95.

[an]

joec, those theories sound really good, so I decide to calculate it out to see if it really make that much sense. Lets assume you have nothing right now and you put $15k each year for the next 5, that’s a total of $75k. Lets also assume you’re in the 25% tax bracket, CA tax is 10%, and you make average 8% a year (obviously this can change wildly depending on your investment strategy and market condition). If you go with ROTH, you pay a total of $26250 in taxes. If you go with Traditional and 5 years from now, you got laid off in January 1st and won’t be able to find another job for a whole year (no additional income that year). With 8% compound interest, your $75k should grow to about $92225. If you convert the whole amount that year, you’re in the 25% federal and 10% tax bracket. Your total tax liability is $32278.75. If you’re unemployed for less than a year, you’d have to add that income into the traditional calculation. If the market crash and you convert at less than $75k, then traditional would be a better bet. If the market grew at more than 8%, you’d have to pay that much more in taxes. So, it’s not as black and white as that article make it out to be. That’s just assume 5 years as well. The longer you’re employed, the more advantageous ROTH becomes, due to the tax free growth. Lets assume all the above variables stay the same and you won’t be out of work until 10 years from now. Roth, your total tax liability is $52500. Traditional, your total tax liability is $80430.95.

[an]

joec, those theories sound really good, so I decide to calculate it out to see if it really make that much sense. Lets assume you have nothing right now and you put $15k each year for the next 5, that’s a total of $75k. Lets also assume you’re in the 25% tax bracket, CA tax is 10%, and you make average 8% a year (obviously this can change wildly depending on your investment strategy and market condition). If you go with ROTH, you pay a total of $26250 in taxes. If you go with Traditional and 5 years from now, you got laid off in January 1st and won’t be able to find another job for a whole year (no additional income that year). With 8% compound interest, your $75k should grow to about $92225. If you convert the whole amount that year, you’re in the 25% federal and 10% tax bracket. Your total tax liability is $32278.75. If you’re unemployed for less than a year, you’d have to add that income into the traditional calculation. If the market crash and you convert at less than $75k, then traditional would be a better bet. If the market grew at more than 8%, you’d have to pay that much more in taxes. So, it’s not as black and white as that article make it out to be. That’s just assume 5 years as well. The longer you’re employed, the more advantageous ROTH becomes, due to the tax free growth. Lets assume all the above variables stay the same and you won’t be out of work until 10 years from now. Roth, your total tax liability is $52500. Traditional, your total tax liability is $80430.95.

[joec]

Actually, I think the main point of the article and what I got out of it is that a traditional ira gives you flexibility on when to pay the tax.

Also, when you did the calculation for the conversion, you didn’t incorporate that we have a progressive tax system in the US (THIS IS CRITICAL). That first 17k in conversion is not taxed at all. The next 16k is at 10%, the next 49k is at 15% according to the article and rest is 25% about 10k. Rough estimates bring that out to around 20k in tax. However, this is also critical, is that you don’t HAVE to do a full 100% conversion in any given year. You can do any amount based on your circumstance that year.

A lot of people look at 2010 and look at how anyone can convert to a Roth, but people were able to do IRA conversions for a while. In my own case, I have converted during a job transition year and paid about 6% tax that whole year. Assuming most readers here are aged 30-40, you have a good 30-40 years before mandatory required minimum distributions.

Also, a lot of financial professionals will probably tell you to NOT do a 100% conversion. The whole goal is to keep the conversion amount in a lower tax bracket so say, if you’re lucky enough to retire at 59 1/2, you can convert every year with no other income (delay social security) till 70 1/2 and in short order (say 10 years till 70 1/2, convert 800k (80k per year) paying 15% tax only). Move to an income tax free state first of course. 🙂

You can convert a bit every single year and that’s the power of the traditional ira vs. the roth 401k where you already paid the highest income tax bracket of your income. The key is that the roth 401k tax is paid at your highest tax bracket while unless you have a pension, the income you take from a traditional ira is at the lowest bracket…

Hope that makes sense. 🙂

Again, I’ve been in the Roth camp for a while, but unless you have really high retirement income from social security or pensions, there really is no other income source to fill your exemptions, deductions, etc…

[joec]

Actually, I think the main point of the article and what I got out of it is that a traditional ira gives you flexibility on when to pay the tax.

Also, when you did the calculation for the conversion, you didn’t incorporate that we have a progressive tax system in the US (THIS IS CRITICAL). That first 17k in conversion is not taxed at all. The next 16k is at 10%, the next 49k is at 15% according to the article and rest is 25% about 10k. Rough estimates bring that out to around 20k in tax. However, this is also critical, is that you don’t HAVE to do a full 100% conversion in any given year. You can do any amount based on your circumstance that year.

A lot of people look at 2010 and look at how anyone can convert to a Roth, but people were able to do IRA conversions for a while. In my own case, I have converted during a job transition year and paid about 6% tax that whole year. Assuming most readers here are aged 30-40, you have a good 30-40 years before mandatory required minimum distributions.

Also, a lot of financial professionals will probably tell you to NOT do a 100% conversion. The whole goal is to keep the conversion amount in a lower tax bracket so say, if you’re lucky enough to retire at 59 1/2, you can convert every year with no other income (delay social security) till 70 1/2 and in short order (say 10 years till 70 1/2, convert 800k (80k per year) paying 15% tax only). Move to an income tax free state first of course. 🙂

You can convert a bit every single year and that’s the power of the traditional ira vs. the roth 401k where you already paid the highest income tax bracket of your income. The key is that the roth 401k tax is paid at your highest tax bracket while unless you have a pension, the income you take from a traditional ira is at the lowest bracket…

Hope that makes sense. 🙂

Again, I’ve been in the Roth camp for a while, but unless you have really high retirement income from social security or pensions, there really is no other income source to fill your exemptions, deductions, etc…

[joec]

Actually, I think the main point of the article and what I got out of it is that a traditional ira gives you flexibility on when to pay the tax.

Also, when you did the calculation for the conversion, you didn’t incorporate that we have a progressive tax system in the US (THIS IS CRITICAL). That first 17k in conversion is not taxed at all. The next 16k is at 10%, the next 49k is at 15% according to the article and rest is 25% about 10k. Rough estimates bring that out to around 20k in tax. However, this is also critical, is that you don’t HAVE to do a full 100% conversion in any given year. You can do any amount based on your circumstance that year.

A lot of people look at 2010 and look at how anyone can convert to a Roth, but people were able to do IRA conversions for a while. In my own case, I have converted during a job transition year and paid about 6% tax that whole year. Assuming most readers here are aged 30-40, you have a good 30-40 years before mandatory required minimum distributions.

Also, a lot of financial professionals will probably tell you to NOT do a 100% conversion. The whole goal is to keep the conversion amount in a lower tax bracket so say, if you’re lucky enough to retire at 59 1/2, you can convert every year with no other income (delay social security) till 70 1/2 and in short order (say 10 years till 70 1/2, convert 800k (80k per year) paying 15% tax only). Move to an income tax free state first of course. 🙂

You can convert a bit every single year and that’s the power of the traditional ira vs. the roth 401k where you already paid the highest income tax bracket of your income. The key is that the roth 401k tax is paid at your highest tax bracket while unless you have a pension, the income you take from a traditional ira is at the lowest bracket…

Hope that makes sense. 🙂

Again, I’ve been in the Roth camp for a while, but unless you have really high retirement income from social security or pensions, there really is no other income source to fill your exemptions, deductions, etc…

[joec]

Actually, I think the main point of the article and what I got out of it is that a traditional ira gives you flexibility on when to pay the tax.

Also, when you did the calculation for the conversion, you didn’t incorporate that we have a progressive tax system in the US (THIS IS CRITICAL). That first 17k in conversion is not taxed at all. The next 16k is at 10%, the next 49k is at 15% according to the article and rest is 25% about 10k. Rough estimates bring that out to around 20k in tax. However, this is also critical, is that you don’t HAVE to do a full 100% conversion in any given year. You can do any amount based on your circumstance that year.

A lot of people look at 2010 and look at how anyone can convert to a Roth, but people were able to do IRA conversions for a while. In my own case, I have converted during a job transition year and paid about 6% tax that whole year. Assuming most readers here are aged 30-40, you have a good 30-40 years before mandatory required minimum distributions.

Also, a lot of financial professionals will probably tell you to NOT do a 100% conversion. The whole goal is to keep the conversion amount in a lower tax bracket so say, if you’re lucky enough to retire at 59 1/2, you can convert every year with no other income (delay social security) till 70 1/2 and in short order (say 10 years till 70 1/2, convert 800k (80k per year) paying 15% tax only). Move to an income tax free state first of course. 🙂

You can convert a bit every single year and that’s the power of the traditional ira vs. the roth 401k where you already paid the highest income tax bracket of your income. The key is that the roth 401k tax is paid at your highest tax bracket while unless you have a pension, the income you take from a traditional ira is at the lowest bracket…

Hope that makes sense. 🙂

Again, I’ve been in the Roth camp for a while, but unless you have really high retirement income from social security or pensions, there really is no other income source to fill your exemptions, deductions, etc…

[joec]

Actually, I think the main point of the article and what I got out of it is that a traditional ira gives you flexibility on when to pay the tax.

Also, when you did the calculation for the conversion, you didn’t incorporate that we have a progressive tax system in the US (THIS IS CRITICAL). That first 17k in conversion is not taxed at all. The next 16k is at 10%, the next 49k is at 15% according to the article and rest is 25% about 10k. Rough estimates bring that out to around 20k in tax. However, this is also critical, is that you don’t HAVE to do a full 100% conversion in any given year. You can do any amount based on your circumstance that year.

A lot of people look at 2010 and look at how anyone can convert to a Roth, but people were able to do IRA conversions for a while. In my own case, I have converted during a job transition year and paid about 6% tax that whole year. Assuming most readers here are aged 30-40, you have a good 30-40 years before mandatory required minimum distributions.

Also, a lot of financial professionals will probably tell you to NOT do a 100% conversion. The whole goal is to keep the conversion amount in a lower tax bracket so say, if you’re lucky enough to retire at 59 1/2, you can convert every year with no other income (delay social security) till 70 1/2 and in short order (say 10 years till 70 1/2, convert 800k (80k per year) paying 15% tax only). Move to an income tax free state first of course. 🙂

You can convert a bit every single year and that’s the power of the traditional ira vs. the roth 401k where you already paid the highest income tax bracket of your income. The key is that the roth 401k tax is paid at your highest tax bracket while unless you have a pension, the income you take from a traditional ira is at the lowest bracket…

Hope that makes sense. 🙂

Again, I’ve been in the Roth camp for a while, but unless you have really high retirement income from social security or pensions, there really is no other income source to fill your exemptions, deductions, etc…

[an]

You’re right about that main point, and I definitely agree with that point. I think the main advantage of Roth is the tax free growth. In your calculation, you only consider federal income tax. If you plan to retire in a no income tax state, then great, but I plan to retire right here in SD, so I’d have to add about 10% on top of that.

You’re right regarding the progressive tax code. I totally forgot about that. It does bring the federal tax rate down from the 25% I was using to calculate. So, let me try this again. Assuming someone is 30, and start saving for retirement now and put $15k/yr away. Lets assume this individual stay w/in the 25% fed tax rate (to make things simpler). This person will retire at age 60. Over 30 years, this person put away $450k into their 401k. Lets assume there’s no major gap in employment and the investment grow at 8% over 30 years. With Roth, you’re paying $112k in federal tax. With traditional, that $450k should grow to $1,879,213.91. Lets assume you’re splitting that $1.8M up over time so you’ll stay w/in the 25% tax bracket, so the effective tax rate due to the progressive tax code will be 15% as you mentioned. 15% of the $1.8M is $281882. So, you’re still going to pay roughly $170k more in taxes.

The other big advantage of Roth vs traditional is required minimum distributions. Roth does not have that until you die, while traditional require you to take $ out at age 70.5. It really depends on how big is your nest egg outside of your retirement account. If you did a good job in saving for retirement beyond your 401k/IRA, having a Roth means you don’t have to take $ out and raise your tax bracket when you don’t really need to. People in the middle of the 25% tax bracket, should be able to save about $1k-3k/month beyond maxing 401k/IRA. If that person invest and get 8% return over 30 years, they should have a nest egg of $1.5M-$4.5M in taxable account.

The big unknown is inflation. If inflation go wild or just run faster than it has been for the next 30 years, 8% return would be too small. If we have average deflation over the next 30 years, 8% would be too large. If one bet on inflation, Roth seems even more lucrative while if one bet on deflation between now and retirement, traditional would be a better vehicle. Assuming the deflation will cause your average return to be less than 1.7% over 30 years vs 8%.

[an]

You’re right about that main point, and I definitely agree with that point. I think the main advantage of Roth is the tax free growth. In your calculation, you only consider federal income tax. If you plan to retire in a no income tax state, then great, but I plan to retire right here in SD, so I’d have to add about 10% on top of that.

You’re right regarding the progressive tax code. I totally forgot about that. It does bring the federal tax rate down from the 25% I was using to calculate. So, let me try this again. Assuming someone is 30, and start saving for retirement now and put $15k/yr away. Lets assume this individual stay w/in the 25% fed tax rate (to make things simpler). This person will retire at age 60. Over 30 years, this person put away $450k into their 401k. Lets assume there’s no major gap in employment and the investment grow at 8% over 30 years. With Roth, you’re paying $112k in federal tax. With traditional, that $450k should grow to $1,879,213.91. Lets assume you’re splitting that $1.8M up over time so you’ll stay w/in the 25% tax bracket, so the effective tax rate due to the progressive tax code will be 15% as you mentioned. 15% of the $1.8M is $281882. So, you’re still going to pay roughly $170k more in taxes.

The other big advantage of Roth vs traditional is required minimum distributions. Roth does not have that until you die, while traditional require you to take $ out at age 70.5. It really depends on how big is your nest egg outside of your retirement account. If you did a good job in saving for retirement beyond your 401k/IRA, having a Roth means you don’t have to take $ out and raise your tax bracket when you don’t really need to. People in the middle of the 25% tax bracket, should be able to save about $1k-3k/month beyond maxing 401k/IRA. If that person invest and get 8% return over 30 years, they should have a nest egg of $1.5M-$4.5M in taxable account.

The big unknown is inflation. If inflation go wild or just run faster than it has been for the next 30 years, 8% return would be too small. If we have average deflation over the next 30 years, 8% would be too large. If one bet on inflation, Roth seems even more lucrative while if one bet on deflation between now and retirement, traditional would be a better vehicle. Assuming the deflation will cause your average return to be less than 1.7% over 30 years vs 8%.

[an]

You’re right about that main point, and I definitely agree with that point. I think the main advantage of Roth is the tax free growth. In your calculation, you only consider federal income tax. If you plan to retire in a no income tax state, then great, but I plan to retire right here in SD, so I’d have to add about 10% on top of that.

You’re right regarding the progressive tax code. I totally forgot about that. It does bring the federal tax rate down from the 25% I was using to calculate. So, let me try this again. Assuming someone is 30, and start saving for retirement now and put $15k/yr away. Lets assume this individual stay w/in the 25% fed tax rate (to make things simpler). This person will retire at age 60. Over 30 years, this person put away $450k into their 401k. Lets assume there’s no major gap in employment and the investment grow at 8% over 30 years. With Roth, you’re paying $112k in federal tax. With traditional, that $450k should grow to $1,879,213.91. Lets assume you’re splitting that $1.8M up over time so you’ll stay w/in the 25% tax bracket, so the effective tax rate due to the progressive tax code will be 15% as you mentioned. 15% of the $1.8M is $281882. So, you’re still going to pay roughly $170k more in taxes.

The other big advantage of Roth vs traditional is required minimum distributions. Roth does not have that until you die, while traditional require you to take $ out at age 70.5. It really depends on how big is your nest egg outside of your retirement account. If you did a good job in saving for retirement beyond your 401k/IRA, having a Roth means you don’t have to take $ out and raise your tax bracket when you don’t really need to. People in the middle of the 25% tax bracket, should be able to save about $1k-3k/month beyond maxing 401k/IRA. If that person invest and get 8% return over 30 years, they should have a nest egg of $1.5M-$4.5M in taxable account.

The big unknown is inflation. If inflation go wild or just run faster than it has been for the next 30 years, 8% return would be too small. If we have average deflation over the next 30 years, 8% would be too large. If one bet on inflation, Roth seems even more lucrative while if one bet on deflation between now and retirement, traditional would be a better vehicle. Assuming the deflation will cause your average return to be less than 1.7% over 30 years vs 8%.

[an]

You’re right about that main point, and I definitely agree with that point. I think the main advantage of Roth is the tax free growth. In your calculation, you only consider federal income tax. If you plan to retire in a no income tax state, then great, but I plan to retire right here in SD, so I’d have to add about 10% on top of that.

You’re right regarding the progressive tax code. I totally forgot about that. It does bring the federal tax rate down from the 25% I was using to calculate. So, let me try this again. Assuming someone is 30, and start saving for retirement now and put $15k/yr away. Lets assume this individual stay w/in the 25% fed tax rate (to make things simpler). This person will retire at age 60. Over 30 years, this person put away $450k into their 401k. Lets assume there’s no major gap in employment and the investment grow at 8% over 30 years. With Roth, you’re paying $112k in federal tax. With traditional, that $450k should grow to $1,879,213.91. Lets assume you’re splitting that $1.8M up over time so you’ll stay w/in the 25% tax bracket, so the effective tax rate due to the progressive tax code will be 15% as you mentioned. 15% of the $1.8M is $281882. So, you’re still going to pay roughly $170k more in taxes.

The other big advantage of Roth vs traditional is required minimum distributions. Roth does not have that until you die, while traditional require you to take $ out at age 70.5. It really depends on how big is your nest egg outside of your retirement account. If you did a good job in saving for retirement beyond your 401k/IRA, having a Roth means you don’t have to take $ out and raise your tax bracket when you don’t really need to. People in the middle of the 25% tax bracket, should be able to save about $1k-3k/month beyond maxing 401k/IRA. If that person invest and get 8% return over 30 years, they should have a nest egg of $1.5M-$4.5M in taxable account.

The big unknown is inflation. If inflation go wild or just run faster than it has been for the next 30 years, 8% return would be too small. If we have average deflation over the next 30 years, 8% would be too large. If one bet on inflation, Roth seems even more lucrative while if one bet on deflation between now and retirement, traditional would be a better vehicle. Assuming the deflation will cause your average return to be less than 1.7% over 30 years vs 8%.

[Author]

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