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In
this chapter:
Introduction
Retirement
savings plans
The
401(k) plan
IRAs
Roth
IRAs
The
IRA decision
How
your savings grow
Some
(minor) drawbacks
Dividing
your savings
Inflation
& taxation
A
newfangled pension
Questions
& answers
Security
and your 401(k)
The
scoop on IRAs
Your
savings priorities
If
you're self-employed
Financial
cramming
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1
2
3
4
5
6 7
8
9
10
11
12
13
14
15
16
17
The
IRA Decision
Richard,
single and 26, does not have the option of participating in a
401(k) plan at work. He has never contributed to an IRA but wants
to start. Problem is, he hasn’t made up his mind whether to go
with a deductible IRA or a Roth IRA. At times like this, you have
to get down to the numbers. So bear with me as we take a look
at two possible IRA scenarios for Richard, each showing why he
would probably do better with a Roth.
First,
let’s say that Richard can only fit $1,000 in IRA contributions
into his budget this year. He has two choices: He can simply deposit
$1,000 into a Roth IRA; or he can put $1,389 into a deductible
IRA and then save $389 in income taxes, by deducting his contribution
from his taxable income. (Richard is in the 28% tax bracket, and
28% of $1,389 is $389.) The money in a Roth IRA will never be
taxed, but if Richard chooses the deductible IRA, he will
have to pay taxes when he withdraws the money at retirement. For
this example, I’ve assumed an annual return of 10% on Richard’s
IRA. If his tax bracket at retirement is the same as it is now—28%—then
neither IRA offers an economic advantage:
| |
Deductible IRA |
Roth IRA |
| Contribution to
IRA |
$1,389 |
$1,000 |
| Deduction |
$389 |
$0 |
| Cost of contribution |
$1,000 |
$1,000 |
| Value of IRA in
30 years |
$24,237 |
$17,450 |
| Taxes paid on
withdrawal |
$6,786 |
$0 |
| After-tax value
in 30 years |
$17,450 |
$17,450 |
It’s
a draw. So why should Richard go with a Roth? Because Roth IRAs
have more flexible rules for withdrawals. What’s more, Richard
won’t have to scrounge up the extra $389 and wait to get it back
at tax time.
Now,
let’s say that Richard can afford to make a $2,000 contribution
to an IRA this year. If he goes for a traditional IRA, Richard
will be able to deduct $560, but he can’t put that money in his
IRA, because IRA contributions are limited to $2,000 a year. So
he will have to invest that $560 in a taxable account. Here are
his options:
| |
Deductible IRA |
Roth IRA |
| Contribution to
IRA |
$2,000 |
$2,000 |
| Deduction |
$560 |
$0 |
| Contribution to
taxable account |
$560 |
$0 |
| Cost of contributions |
$2,000 |
$2,000 |
| Value of IRA in
30 years |
$34,900 |
$34,900 |
| Taxes paid on
withdrawal |
$9,772 |
$0 |
| Value of taxable
account in 30 years |
$5,635 |
$0 |
| Total after-tax
value in 30 years |
$30,763 |
$34,900 |
In
this example I’ve assumed that the earnings on Richard’s taxable
account get hit with a 20% tax every year. But even if they are
taxed less, they will never be able to earn as much as the money
in a Roth IRA, which is not subject to federal income tax at all.
Richard should get a Roth.
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