Do Roth accounts always lose?

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Do Roth accounts always lose?

Postby monocle » Sun Sep 01, 2013 1:30 am

I've been trying to see the point of a Roth recently and did a bunch of calculations based on contributions and distributions and everything I'm calculating comes up with the Roth as a loser.

Person A. Roth account investor.
Person B. Traditional account investor.

Assumptions:

Same growth rate on accounts.

Situation 1:
If person A contributes the maximum to the Roth, then person B contributes maximum to the Traditional and then invests the tax savings.
(e.g. current 25% marginal tax bracket: A contributes 5500 to Roth, B contributes 5500 to Traditional and 1,375 to brokerage account)

Situation 1 conclusion: A has less in accounts than B when withdrawals begin.

Situation 2:
If person A contributes under the maximum to the Roth, then person B contributes the same+tax savings into the Traditional.
(e.g. current 25% marginal tax bracket: A contributes 3000 to Roth, B contributes 3000+750).

Situation 2 conclusion: A has less in accounts than B when withdrawals begin.

Contributions are made from the top of the marginal tax rate.
Person A is eating a 25% tax now.
Person B is saving a 25% tax now.

Distributions are based on the retirement effective rate not marginal rate.

Based on 2010 tax rates: (slightly higher now)
Effective tax rates are as follows:
Income Effective Tax Rate
1-15,000 -14%
15,000-30,000 -5%
30,000-50,000 3%
50,000-100,000 8%
100,000-250,000 13%
250,000-1Mill 22%
1Mill or more 23%

Average senior income in the US in 2010: 35,000 dollars meaning an effective rate of 3%.

Mean current income in the US is about 50,000 making for a marginal tax rate of 15%.

15% - 3% = 12% = Traditional Wins

A person making 100,000 per year today and pulling 100,000 per year in retirement:
Contributions taxed at 25%, Distributions taxed at 13%

25% - 13% = 12% Traditional Wins

A person making 40,000 per year now and pulling 100,000 in retirement.
15% on contributions, 13% on distributions.
15%-13% = 2% Traditional Wins

I can understand doing a backdoor Roth if you have already met your contribution limits for the traditional space as the costs are the same, but under no other circumstance can I see the point of contributing to a Roth first. Maybe for inheritance tax avoidance?

It seems that most of the Traditional vs Roth arguments I see online are based on marginal tax rates for contributions and distributions. The flaw there being that the distributions should be treated at the effective tax rate not the marginal.

Is my thinking above flawed in some major way that I am not seeing?

I've got three years left to contribute 17,500 to a Roth TSP space before I retire... after which I cannot because of income limits for the regular Roth IRA. Really want to know if I should take advantage of it while I can or continue with my regular TSP.
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Re: Do Roth accounts always lose?

Postby kaneohe » Sun Sep 01, 2013 1:51 am

I suppose it depends on what you are assuming for retirement. Some folks may have a retirement income consisting of a significant base of pension, social security, and perhaps investment distributions. If this base is large enough, retirement fund withdrawals may be a small fraction of the total and marginal tax rate seems applicable. If the retirement fund withdrawal is overwhelmingly dominant, then perhaps effective or average rate might apply. In reality, it might be something in between.
It is possible if the retirement funds are large enough that RMDs would increase the tax rates as high or higher in retirement than while working.
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Re: Do Roth accounts always lose?

Postby monocle » Sun Sep 01, 2013 2:00 am

kaneohe wrote:I suppose it depends on what you are assuming for retirement. Some folks may have a retirement income consisting of a significant base of pension, social security, and perhaps investment distributions. If this base is large enough, retirement fund withdrawals may be a small fraction of the total and marginal tax rate seems applicable. If the retirement fund withdrawal is overwhelmingly dominant, then perhaps effective or average rate might apply. In reality, it might be something in between.
It is possible if the retirement funds are large enough that RMDs would increase the tax rates as high or higher in retirement than while working.


I see what you mean and calculated various ways based on a big pension... but it all came down to the marginal contributions and effective distributions.
e.g. a guy making 70,000 now in the 25% tax bracket... even with a 500,000 dollar per year pension is paying an effective tax of 22% later.
25%-22% = 3% win for the traditional. In a close case like this, I could see the fear of increased future tax rates, but what are the chances a guy earning 70K now would have a 500,000 dollar per year pension later?
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Re: Do Roth accounts always lose?

Postby kaneohe » Sun Sep 01, 2013 2:47 am

[url]Not sure where your effective rates are coming from........to me it looks like for single, 36K or so is the top of the 15% bracket .
If you had SS of 24K and 15K of investment income and 20K of 401K distributions , seems like you'd fill the lower brackets w/ this base and have an effective tax rate for further income, e.g. TIRA distributions of 25% or so.
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Re: Do Roth accounts always lose?

Postby monocle » Sun Sep 01, 2013 2:56 am

kaneohe wrote:[url]Not sure where your effective rates are coming from........to me it looks like for single, 36K or so is the top of the 15% bracket .
If you had SS of 24K and 15K of investment income and 20K of 401K distributions , seems like you'd fill the lower brackets w/ this base and have an effective tax rate for further income, e.g. TIRA distributions of 25% or so.


For this post I used the information from here:
http://taxfoundation.org/blog/chart-day ... e-category

For my calculations I used current tax rates and a standard deduction.
The website above is much lower than my calculated effective rates, but both still proved lower than the marginal contribution rates.

Here is one from 2012
http://www.pgpf.org/Issues/Taxes/2012/0 ... -explainer
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Re: Do Roth accounts always lose?

Postby monocle » Sun Sep 01, 2013 3:25 am

Here is an example of one my calculations...
Person in the current 25% tax bracket is putting into:
ROTH: 10,000
or putting into
TRADITIONAL: 12,500 (investing the tax savings)

Investment period 20 years
With 12% return

BASED on pulling both accounts into cash at the end of the investment period:
ROTH TOTAL: $720,524.42
TRAD TOTAL: $900,655.53

BOTH SITUATIONS GET:
16,2100 social security
22,000 annual pension
(38,210 total extra taxable)

6100 standard deduction during retirement.

Based on 4% withdrawal rate for 25 years...

Roth End Game
Income From Roth $28,820.98
Income From Roth+other $67,030.98
Taxable Income Total $32,110.00
Taxes $3,924.00
Net $63,106.98 per year
Effective Tax Rate 6.22%

Traditional End Game
Income From Trad $36,026.22
Income From Trad+other $74,236.22
Taxable Income Total $68,136.22
Taxes $9,327.93
Net $64,908.29 per year
Effective Tax Rate 14.37%

Difference
Annual traditional advantage: 1,801.31
25 year advantage = 45,032.78
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Re: Do Roth accounts always lose?

Postby kaneohe » Sun Sep 01, 2013 4:47 am

well, you must be on the West coast or maybe HI so you're going to have the last say for tonite anyway.......

you might want to use a tax calculator to do the calculations esp. w/ SS since it's a bit tricky if you haven't done it before
(I'm thinking you're a young whippersnapper :happy ). I used this one http://www.hrblock.com/free-tax-tips-calculators/tax-calculator-home.html

I probably used a different assumption than you on the age (I assumed 65) so probably used a higher std deduction than you
but anyway w/ that I think I found that the taxes were 1568 for Roth vs 11181 for TIRA and with those numbers got
net after tax 65463 for Roth and 63055 for TIRA. Too late to guarantee anything but I'll let you play w/ the tax calculator
and see what you get.
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Re: Do Roth accounts always lose?

Postby frugaltype » Sun Sep 01, 2013 5:08 am

monocle wrote:Investment period 20 years
With 12% return


??
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Re: Do Roth accounts always lose?

Postby monocle » Sun Sep 01, 2013 5:23 am

kaneohe wrote:well, you must be on the West coast or maybe HI so you're going to have the last say for tonite anyway.......

you might want to use a tax calculator to do the calculations esp. w/ SS since it's a bit tricky if you haven't done it before
(I'm thinking you're a young whippersnapper :happy ). I used this one http://www.hrblock.com/free-tax-tips-calculators/tax-calculator-home.html

I probably used a different assumption than you on the age (I assumed 65) so probably used a higher std deduction than you
but anyway w/ that I think I found that the taxes were 1568 for Roth vs 11181 for TIRA and with those numbers got
net after tax 65463 for Roth and 63055 for TIRA. Too late to guarantee anything but I'll let you play w/ the tax calculator
and see what you get.


Forgot to mention I was basing all this on Married Filing Jointly at retirement.

If filing single at retirement, the Roth does gain the edge with the above example...
Roth Advantage Annual
$1,387.21

Roth Advantage 25 years
$34,680.28

The Roth has the advantage for the single guy at the 28% rate as well.
Switched the contribution tax rate up to 33% with the above example and then Single or Married Filing Jointly both end up with a win for the Traditional.


So it is starting to look like if you are single and in the 28% tax bracket or below and plan to remain single... Roth is the way to go, otherwise use Traditional.
The Roth advantage for the above example goes away if there is no pension and only SS.
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Re: Do Roth accounts always lose?

Postby SGM » Sun Sep 01, 2013 5:30 am

I don't know where effective tax rates come into the calculation. If you are looking at the last dollars invested or taken out, don't you need to look at your marginal rate. Well that is what I do. Assuming you have no control over your other income then use the marginal rate for each dollar that you either put into or take out of the IRAs.

I also look at the buying power of a tIRA vs. a Roth.

750,000 buying power for a Roth in the 25% bracket.
Buying power for the 900,655 tIRA is 675,491. That is 75% of the tIRA.

Also at age 70 1/2 you need to take a required minimum distribution which goes up every year and could increase your tax rate.
For 900,655 the first year's rmd is 32,870 and goes up yearly.

I only expect my tax rates to go up, so I have converted 80% to Roths.
If I thought my rates would go down, I certainly would not convert.
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Re: Do Roth accounts always lose?

Postby monocle » Sun Sep 01, 2013 5:32 am

frugaltype wrote:
monocle wrote:Investment period 20 years
With 12% return


??


The rate doesn't matter too much... chose 12% as it is close to the non inflation adjusted SP500 historic.
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Re: Do Roth accounts always lose?

Postby sperry8 » Sun Sep 01, 2013 5:57 am

This is very interesting. I've always heard Roth is the no brainer too - but never converted. I am single and in the 28% tax bracket. I just couldn't swallow paying all those taxes now. Even though you show that a single guy (who remains so) in the 28% bracket wins - you're making me think there are enough unknowns that switching would be silly (which I didn't plan anyway).

Can't wait til all the smartest bogleheads in the room wake up and can comment.

btw, welcome to the forum!
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Re: Do Roth accounts always lose?

Postby monocle » Sun Sep 01, 2013 6:57 am

sperry8 wrote:This is very interesting. I've always heard Roth is the no brainer too - but never converted. I am single and in the 28% tax bracket. I just couldn't swallow paying all those taxes now. Even though you show that a single guy (who remains so) in the 28% bracket wins - you're making me think there are enough unknowns that switching would be silly (which I didn't plan anyway).

Can't wait til all the smartest bogleheads in the room wake up and can comment.

btw, welcome to the forum!


I'm the same way, can't stand to write the tax checks. Held a funeral for the big one last year.

SGM wrote:I don't know where effective tax rates come into the calculation. If you are looking at the last dollars invested or taken out, don't you need to look at your marginal rate. Well that is what I do. Assuming you have no control over your other income then use the marginal rate for each dollar that you either put into or take out of the IRAs.



When everything you read is telling you the Roth is better, I find myself doubting my math, even though I know it is correct. Even the wiki on this site is saying to compare marginal rates at contribution to marginal at distribution. I just don't see the logic in that. Am I missing something obvious? I mean, when we contribute... it is taken off the top marginal rate (e.g. 25% rate, 10,000 dollar contribution = a real actual 2,500 tax savings) ... when we withdraw it, it is mixed in with everything else we have, thus the effective rate. I could see treating it as marginal at distribution, if we were tracking the specific return of the account, but at distribution we have to mix it with all other sources of income... and treat it as part of the whole income.

When I get some time, I'm going to try to clean up my excel calculator and make it usable for others and then upload it. Right now it is a bit messy.
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Re: Do Roth accounts always lose?

Postby ks289 » Sun Sep 01, 2013 7:32 am

As some of the other posters and the wiki state, marginal rates are appropriate for the comparison between Roth and traditional because in this comparison the other sources of income (SS, pension) which will occupy the lowest brackets will not change whether you use roth or traditional. The traditional Ira distributions must be considered the "last" dollars of income taxed at the marginal rate.

If there are more taxable investments as a result of using the traditional Ira then yes that would impact the calculation.
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Re: Do Roth accounts always lose?

Postby FedGuy » Sun Sep 01, 2013 7:33 am

My income has varied pretty substantially over the years, and I've moved between states several times. I tend to save in traditional 401(k)s but then convert to Roth IRAs in years where I'm either earning less income, living in a state with lower taxes, or both. I never did the math to confirm that that's the best payout for me, but if I didn't do that I'd probably leave the money that I use to pay the taxes on the conversion in cash, which would violate the assumptions of your model.
Last edited by FedGuy on Sun Sep 01, 2013 12:24 pm, edited 1 time in total.
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Re: Do Roth accounts always lose?

Postby bsteiner » Sun Sep 01, 2013 8:07 am

Monocle is correct that if you can contribute to a traditional when in a high bracket and withdraw or convert when in a low bracket, the traditional will usually be better. Indeed, that's the most common scenario.

However, FedGuy is also correct that if the Roth conversion is generally beneficial to the extent you can convert at a low bracket. In other words, the Roth conversion is generally beneficial to the extent you can convert at the same rate, a lower rate, or a slightly (but not too much) higher rate than would otherwise apply to the distributions.
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Re: Do Roth accounts always lose?

Postby nisiprius » Sun Sep 01, 2013 8:11 am

monocle wrote:Situation 1:
If person A contributes the maximum to the Roth, then person B contributes maximum to the Traditional and then invests the tax savings.
(e.g. current 25% marginal tax bracket: A contributes 5500 to Roth, B contributes 5500 to Traditional and 1,375 to brokerage account)
Whoa, whoa, whoa there. WHAT "tax savings?" Traditional IRAs haven't been deductible for a very long time, unless you meet a whole bunch of rather stringent criteria that I've never been able to meet.

Admittedly I haven't looked at this recently--has there been some recent change? Did they bring back the deductible IRA? I'd have thought there would be screaming headlines...

When the IRA first came out contributions WERE deductible, and I contributed for several years. Then they eliminated the deductibility. From 1990 through retirement, there was exactly ONE year, ONE when I thought I was eligible because I was at a cheapskate employer with no retirement plan at all. So I contributed. When I got my W2, to my horror, the "retirement plan" box was checked. It turned out they had some strange kind of marginal thing they called a "profit sharing plan," and they had shared $27.18 in profits with me that year, thereby counting as deferred compensation and disqualifying me from a deductible IRA.

Why do you think you are eligible to deduct your contributions, and have you double-checked that?
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Re: Do Roth accounts always lose?

Postby The Wizard » Sun Sep 01, 2013 8:28 am

Similar to some others, the $6000 a year I contributed to my Roth IRA my last several working years was a small fraction of the amount contributed to my 403(b). And withdrawals from my Roth, if they ever happen will be on top of a healthy base retirement income, so I'm happy not to have to pay taxes on that.
And as Nisi says, a tIRA wouldn't have had deductible contribs anyhow...
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Re: Do Roth accounts always lose?

Postby cflannagan » Sun Sep 01, 2013 8:37 am

nisiprius wrote:
monocle wrote:Situation 1:
If person A contributes the maximum to the Roth, then person B contributes maximum to the Traditional and then invests the tax savings.
(e.g. current 25% marginal tax bracket: A contributes 5500 to Roth, B contributes 5500 to Traditional and 1,375 to brokerage account)
Whoa, whoa, whoa there. WHAT "tax savings?" Traditional IRAs haven't been deductible for a very long time, unless you meet a whole bunch of rather stringent criteria that I've never been able to meet.

Admittedly I haven't looked at this recently--has there been some recent change? Did they bring back the deductible IRA? I'd have thought there would be screaming headlines...

When the IRA first came out contributions WERE deductible, and I contributed for several years. Then they eliminated the deductibility. From 1990 through retirement, there was exactly ONE year, ONE when I thought I was eligible because I was at a cheapskate employer with no retirement plan at all. So I contributed. When I got my W2, to my horror, the "retirement plan" box was checked. It turned out they had some strange kind of marginal thing they called a "profit sharing plan," and they had shared $27.18 in profits with me that year, thereby counting as deferred compensation and disqualifying me from a deductible IRA.

Why do you think you are eligible to deduct your contributions, and have you double-checked that?


From IRS.gov:

For 2013 the phaseout range for deducting an IRA contribution when you are covered by a retirement plan at work are as follows:
For single filers: $59,000 to $69,000
For head of household filers: $59,000 to $69,000
For married couples filing jointly: $95,000 to $115,000
For married couples filing separately: $0 to $10,000
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Re: Do Roth accounts always lose?

Postby ThatGuy » Sun Sep 01, 2013 8:51 am

cflannagan wrote:From IRS.gov:

For 2013 the phaseout range for deducting an IRA contribution when you are covered by a retirement plan at work are as follows:
For single filers: $59,000 to $69,000
For head of household filers: $59,000 to $69,000
For married couples filing jointly: $95,000 to $115,000
For married couples filing separately: $0 to $10,000


Dang, I logged in just to mention this. Especially if you're on the coast, it's really easy to blow through those limits. And you still might feel that you don't make enough to live the life you want :D
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Re: Do Roth accounts always lose?

Postby gvsucavie03 » Sun Sep 01, 2013 9:12 am

All of these calculations were also based on the assumption that you would reinvest the tax savings... some of us like me would re-set the number of exemptions so our take-home pay would go up and we would then run our regular household budget with that extra cash. If not, I would have to wait until tax time for that interest-free loan I gave the government to come back to invest it (or figure out my exact tax savings and invest the difference each pay period, which I think is possible, but not very feasible).

I think most of us in the 10-15% brackets now are anticipating (assuming tax tables don't change dramatically) a higher income in retirement and therefore be in a higher bracket. I also have a pension, so that steers me towards the Roth even more.

And yes, this assumes you are even eligible for the full deduction of the Trad. IRA....
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Re: Do Roth accounts always lose?

Postby grabiner » Sun Sep 01, 2013 10:03 am

If the choice is all-Roth versus all-traditional, the Roth loses. If you go all-traditional and have little or no other income in retirement, you deduct your traditional contributions in the 25% bracket, and then you pay tax in retirement in a mix of the 0%, 10%, 15%, and 25% brackets, so you get more than the tax-free return that a Roth gives.

But the choice isn't all-Roth versus all-traditional; it is between making Roth and traditional contributions each year, and possibly even a mix in the same year (if your employer doesn't offer a Roth 401(k) but you have the choice between a traditional and a Roth IRA). If your other contributions will put you at a 25% marginal tax rate in retirement, and you have a 25% marginal tax rate now, then investing $3000 in a Roth or $4000 in a traditional account will give you the same amount to spend; if this account doubles before you withdraw it, the $8000 will lead to $6000 in extra tax. And if you max out your tax-deferred accounts and have to invest the tax benefits from the traditional account in a taxable account, the Roth comes out ahead.
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Re: Do Roth accounts always lose?

Postby nisiprius » Sun Sep 01, 2013 10:03 am

In point of fact we have always blown through the tax savings from the 401(k).

Not a recommendation, absolutely a "don't do as I do." Not a statement that stronger-minded people might not do better, more like a confession. Actually it's sort of hard to figure out what we DID do. We tended to adjust our W4 exemptions count and our estimated tax payments to roughly equal our tax obligation, but with a preference for getting a refund rather than making a payment. The refund, of course, always went straight into the checking account and got treated as a windfall, although it tended to get spent on thing we thought we "needed"--new lawnmower, not vacation. Meanwhile, on the other side, the Roths tended to get funded through an independent seat-of-the-pants decision.

It was always our goal to max out our Roths but sometimes if we were pinched we didn't. Gee, do you suppose the tax savings from the 401(k) improved our monthly finances to the point where we felt flush enough to fund the Roths so they sorta kinda did get reinvested after all?

OK, I have been a lousy record-keeper and have no idea of what we actually did. The odds are we probably blew through the savings.

There's a huge "behavioral" component in all this, you know, because even if you are so disciplined that you reinvest the savings--I would think you would need to do that by calculating it and then setting up automatic contributions to equal it--when you are deciding how much more you can invest, it's awfully hard not to be influenced by the knowledge that you are "re"investing $X. Can you really wall off thought-tight compartment in your mind and pretend you're not reinvesting the tax savings when you are trying to judge how much you can "afford" to save?

It would be interesting to know just how many people do all that much better. And, for that matter, how much better people with "financial advisors" did.
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Re: Do Roth accounts always lose?

Postby kaneohe » Sun Sep 01, 2013 10:06 am

monocle wrote:
Forgot to mention I was basing all this on Married Filing Jointly at retirement.

.


I misinterpreted what you did because you had quoted std deduction of 6100 earlier........which is for a single.
Anyway another factor if MFJ.......at some point, one of the partners may pass away, subjecting the survivor to much higher tax rates (see the tables for single vs MFJ.........actually same rates but they increase at much lower income levels for single).

Some of the confusion may be in the words vs the numbers. When a marginal tax rate is mentioned, sometmes there is talk of the rate on the next $ (or $100). This would apply if you had a large base of other income and then were considering whether to do a TIRA that would stack a relatively small amount of additional income on top of that. If you had no other (taxable) income, and were doing the analysis of whether or not to do the TIRA, then perhaps you might consider the average tax rate (is that the same as effective?) on the TIRA income. If you had an intermediate case , then you might consider the marginal tax rate on the block of TIRA income (that is figure the tax w/ and w/o the TIRA income, not just the next $)
since you might be crossing tax bracket borders.........maybe this is the marginal effective bracket or the effective marginal bracket?

A crude analogy.......suppose you open a restaurant. It costs you 10K a year for your fixed costs (rent/insurance /etc)
and 1cent/ hamburger for the costs directly related to the materials and labor to make that hamburger. You want to know your cost for each hamburger so you can make a profit. Obviously it depends on how you look at it. If you sold 10K units/yr , it costs you 1.01 for each hamburger. If someone offered to buy 20K burgers for 50cents each would you turn them down because you think you would be losing 51 cents on each? Here the fixed costs relate to the average tax rate
and the variable cost of 1 cent relates to the marginal tax rate but if you get misled by the words instead of the math, you might conclude the wrong thing.
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Re: Do Roth accounts always lose?

Postby SeattleCPA » Sun Sep 01, 2013 10:37 am

I think Roth's almost always lose. The reason is that almost always people's marginal rate drops during the years they withdraw from the Roth as compared to the marginal rate during the years one works.

I.e., if you can defer taxes when rate is 25% or 30%... and then you reverse the deferral of taxes when rate is 10% or 15%, you should defer.

But by doing a Roth, lots of time people are paying taxes at the 25% or 30% rate... and then avoiding the "reversal" of the deferral but that tax would be 10% or 15%...

BTW, if you do your math right and the marginal rate both during your working years and during your retirement years is identical, you have a "six of one half a dozen of the other" situation.

For example, to keep the math easy, say before you pay any taxes on the income you have $5000 to invest in a deductible IRA. You will let this money compound over 30 years. Assume it will earn 5%. At the end of thirty years, you have $21,609.71 in your account, something you can verify by copying and pasting this formula into an Excel workbook:

=FV(0.05,30,,-5000)

But that's pre-tax money. So just for illustration purposes, assume you withdraw this money and pay a 25% tax return. The $21,609.71 turns into $16,207.28. That's what you have left over after paying the taxes.

In comparison, if you use a Roth you need to first pay the taxes on the front end. Say this tax equals 25% of your $5,000. So you only get to invest 75% of the $5,000, or $3750. If you take this $3750 and earn 5% over 30 years, you end up with $16,207.28, something you can verify by copying and pasting this formula into an Excel workbook;

=FV(0.05,30,,-5000*(1-0.25))

The neat thing about the Roth future value is that you don't need to pay any income taxes on the money of course. But if the marginal rates are the same as in the examples given here, the after tax future value is the same. To the penny.

The upshot? Using a Roth should mostly be a bet that your marginal rate will rise during retirement.

P.S. When Roths first appeared, most financial advisors, accountants, mutual fund companies didn't seem to understand the math. But to their credit Vanguard very early on was pointing out this weirdness in their literature,
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Re: Do Roth accounts always lose?

Postby ObliviousInvestor » Sun Sep 01, 2013 10:46 am

SeattleCPA wrote:BTW, if you do your math right and the marginal rate both during your working years and during your retirement years is identical, you have a "six of one half a dozen of the other" situation.
[...]
When Roths first appeared, most financial advisors, accountants, mutual fund companies didn't seem to understand the math.

That darned commutative property of multiplication. It gets people every time. :|
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Re: Do Roth accounts always lose?

Postby Texas hold em71 » Sun Sep 01, 2013 11:00 am

nisiprius wrote:In point of fact we have always blown through the tax savings from the 401(k).

Not a recommendation, absolutely a "don't do as I do." Not a statement that stronger-minded people might not do better, more like a confession. Actually it's sort of hard to figure out what we DID do. We tended to adjust our W4 exemptions count and our estimated tax payments to roughly equal our tax obligation, but with a preference for getting a refund rather than making a payment. The refund, of course, always went straight into the checking account and got treated as a windfall, although it tended to get spent on thing we thought we "needed"--new lawnmower, not vacation. Meanwhile, on the other side, the Roths tended to get funded through an independent seat-of-the-pants decision.


Oh my! Never really considered those tax savings as savings! And I consider myself pretty disciplined. We paid our taxes and lived off and invested the difference. I suppose in one way we have out earned some of our less smart decisions. Of course none of you can accuse me of not paying my fair share to Uncle Sam. I'll call it patriotism to save face. :shock:

We have never been able to contribute to a Roth directly since they were invented. Waited a couple of years on back door Roth until they became generally accepted. So for us, it was a no brainier- traditional (401k) won. Did not do a non deductible IRA and chose taxable for simplicity.

I have many years to think about it but my plan now is to convert our 401(k)s to Roth in early part of retirement. There are many benefits to Roth including no RMDs that I find appealing.
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Re: Do Roth accounts always lose?

Postby JamesSFO » Sun Sep 01, 2013 11:02 am

SeattleCPA wrote:I
The upshot? Using a Roth should mostly be a bet that your marginal rate will rise during retirement.

P.S. When Roths first appeared, most financial advisors, accountants, mutual fund companies didn't seem to understand the math. But to their credit Vanguard very early on was pointing out this weirdness in their literature,


This, a thousand times this. A roth is 99% a bet about the direction of your income taxes for most of your savings period.

That said there are wrinkles:

  • During draw down - there are some models that show converting traditional assets to roth assets earlier in retirement can extend the withdrawal period - See http://www.academyfinancial.org/09Conference/09Proceedings/(3B)%20Coopersmith,%20Sumutka,%20Arvesen.pdf
  • Tax deferral diversity - Having different types of tax deferred accounts may allow you choices esp if you want to use it to leave a legacy (no RMDs from Roth)
  • Low cost hedge against changing tax rates - Paying the taxes now on Roth contributions is a relatively low cost hedge if you believe the tax system will have rising rates but that existing Roth's will be grandfathered.
  • Behavioral aspects - Although tax inefficient unless your future tax rate > current tax rate, knowing that you will have tax free income in the future may be desirable

All those said, you still should make 99% of the decision from whether or not you believe tax rates will be higher (Roth) or lower (traditional) in retirement.
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Re: Do Roth accounts always lose?

Postby nisiprius » Sun Sep 01, 2013 11:06 am

Mr. Senile here: as the days of the Required Minimum Distribution start to loom, I have to say that the simplicity of the Roth--just withdraw the money and spend it--looks better and better all the time. Nothing to do, nothing to think about, nothing to set aside for taxes, no worries about how taxable withdrawals from the IRA affect the taxability of Social Security...

...hmmmm, has anyone taken that into account in the discussion yet? I bet the online calculators don't. It's this innocent-looking form that has about nine different inequalities in it; if adjusted deductible is greater than table B if married filing jointly, then subtract net benefits from gross taxable after exemptions and enter the result on line 5 and hunt the treble, but not greater than the minimum of 15% of the combined ages of Mary and Ann when Mary was twice as old as Ann will be when the dominical letter falls after C, except in the words science, fancies, and glacier....

It is actually quite easy to fill out the form. What's really difficult is to figure out the moving parts and make a little chart of the relationship between pre-tax income and after-tax income.
Last edited by nisiprius on Sun Sep 01, 2013 11:12 am, edited 1 time in total.
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Re: Do Roth accounts always lose?

Postby Ged » Sun Sep 01, 2013 11:11 am

Another factor at the end of the game is medical expenses. You are likely to end up with some pretty large deductions that can definitely put you in a very low tax bracket giving you free conversion....
Lack of planning on your part does not constitute an emergency on my part.
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Re: Do Roth accounts always lose?

Postby kaneohe » Sun Sep 01, 2013 11:20 am

monocle wrote:Here is an example of one my calculations...
Person in the current 25% tax bracket is putting into:
ROTH: 10,000
or putting into
TRADITIONAL: 12,500 (investing the tax savings)


I believe bsteiner pointed out in another thread that this probably should be:
Roth: 10,000
TIRA: 13,333 (roth is 75% of TIRA, not 80%, which actually helps your case)
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Re: Do Roth accounts always lose?

Postby ProfessorX » Sun Sep 01, 2013 11:23 am

When I was a graduate student I was paying very low taxes and spending not very much money. I put the max in a Roth IRA every year and it was a great way to save since my taxes were very low to being with because I had such a small income.
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Re: Do Roth accounts always lose?

Postby bertilak » Sun Sep 01, 2013 11:31 am

SeattleCPA wrote:The upshot? Using a Roth should mostly be a bet that your marginal rate will rise during retirement.

What about the following consideration:

  • If one is already retired and gets most of one's income from SS and a DB pension, I think it is safe to assume the tax rate will not go down and those future RMDs will soon push one into a higher bracket. Converting to ROTH will reduce the RMDs.
  • I will only convert what I can without going into a higher bracket.
  • I don't need all (or even much) of the RMDs to meet expenses. I am creating the tax liability only because it is required.
  • The RMD proceeds will be reinvested in a taxable account where only dividends will be taxable, not whatever I withdraw. I will likely never withdraw any cap gains because any money I need will come directly from the RMDs that I already paid tax on.
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Re: Do Roth accounts always lose?

Postby grabiner » Sun Sep 01, 2013 11:56 am

bertilak wrote:
SeattleCPA wrote:The upshot? Using a Roth should mostly be a bet that your marginal rate will rise during retirement.

What about the following consideration:

If one is already retired and gets most of one's income from SS and a DB pension, I think it is safe to assume the tax rate will not go down and those future RMDs will soon push one into a higher bracket. Converting to ROTH will reduce the RMDs.


And even without the DB pension, the effect of the phase-in of Social Security taxation puts many retirees in a 15% tax bracket but with a 27.75% marginal tax rate. Therefore, it is useful to have some traditional funds (to be withdrawn at 15% before you take SS, or converted to Roths if you don't need the money) and some Roths (to be withdrawn when traditional withdrawals are taxed at 27.75%, and made when the traditional contributions were deductible at only 15% or 25%)
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Re: Do Roth accounts always lose?

Postby bertilak » Sun Sep 01, 2013 12:07 pm

grabiner wrote:
bertilak wrote:
SeattleCPA wrote:The upshot? Using a Roth should mostly be a bet that your marginal rate will rise during retirement.

What about the following consideration:

If one is already retired and gets most of one's income from SS and a DB pension, I think it is safe to assume the tax rate will not go down and those future RMDs will soon push one into a higher bracket. Converting to ROTH will reduce the RMDs.


And even without the DB pension, the effect of the phase-in of Social Security taxation puts many retirees in a 15% tax bracket but with a 27.75% marginal tax rate. Therefore, it is useful to have some traditional funds (to be withdrawn at 15% before you take SS, or converted to Roths if you don't need the money) and some Roths (to be withdrawn when traditional withdrawals are taxed at 27.75%, and made when the traditional contributions were deductible at only 15% or 25%)

David,

Can you elaborate on the underlined part? I thought "bracket" meant "marginal."

P.S. I am already at 15% even w/o the RMDs.
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Re: Do Roth accounts always lose?

Postby The Wizard » Sun Sep 01, 2013 12:11 pm

bertilak wrote:
SeattleCPA wrote:The upshot? Using a Roth should mostly be a bet that your marginal rate will rise during retirement.

What about the following consideration:

  • If one is already retired and gets most of one's income from SS and a DB pension, I think it is safe to assume the tax rate will not go down and those future RMDs will soon push one into a higher bracket. Converting to ROTH will reduce the RMDs.
  • I will only convert what I can without going into a higher bracket.
  • I don't need all (or even much) of the RMDs to meet expenses. I am creating the tax liability only because it is required.
  • The RMD proceeds will be reinvested in a taxable account where only dividends will be taxable, not whatever I withdraw. I will likely never withdraw any cap gains because any money I need will come directly from the RMDs that I already paid tax on.

This is almost exactly my case as well.
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Re: Do Roth accounts always lose?

Postby The Wizard » Sun Sep 01, 2013 12:33 pm

bertilak wrote:Can you elaborate on the underlined part? I thought "bracket" meant "marginal."

P.S. I am already at 15% even w/o the RMDs.

It has to do with the phase-in of SS taxation by the IRS, as a function of other income from various sources.
Low income folks have zero percent of their SS taxed.
Middling income folks have up to 50% of their SS taxed.
Higher income folks have up to 85% of their SS taxed.
So when you're in those ramp zones, another $10 of pension income also pushes a portion of SS income into a higher tax zone...
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Re: Do Roth accounts always lose?

Postby Meaty » Sun Sep 01, 2013 12:37 pm

monocle wrote:I've been trying to see the point of a Roth recently and did a bunch of calculations based on contributions and distributions and everything I'm calculating comes up with the Roth as a loser.

Person A. Roth account investor.
Person B. Traditional account investor.

Assumptions:

Same growth rate on accounts.

Situation 1:
If person A contributes the maximum to the Roth, then person B contributes maximum to the Traditional and then invests the tax savings.
(e.g. current 25% marginal tax bracket: A contributes 5500 to Roth, B contributes 5500 to Traditional and 1,375 to brokerage account)

Situation 1 conclusion: A has less in accounts than B when withdrawals begin.

Situation 2:
If person A contributes under the maximum to the Roth, then person B contributes the same+tax savings into the Traditional.
(e.g. current 25% marginal tax bracket: A contributes 3000 to Roth, B contributes 3000+750).

Situation 2 conclusion: A has less in accounts than B when withdrawals begin.

Contributions are made from the top of the marginal tax rate.
Person A is eating a 25% tax now.
Person B is saving a 25% tax now.

Distributions are based on the retirement effective rate not marginal rate.

Based on 2010 tax rates: (slightly higher now)
Effective tax rates are as follows:
Income Effective Tax Rate
1-15,000 -14%
15,000-30,000 -5%
30,000-50,000 3%
50,000-100,000 8%
100,000-250,000 13%
250,000-1Mill 22%
1Mill or more 23%

Average senior income in the US in 2010: 35,000 dollars meaning an effective rate of 3%.

Mean current income in the US is about 50,000 making for a marginal tax rate of 15%.

15% - 3% = 12% = Traditional Wins

A person making 100,000 per year today and pulling 100,000 per year in retirement:
Contributions taxed at 25%, Distributions taxed at 13%

25% - 13% = 12% Traditional Wins

A person making 40,000 per year now and pulling 100,000 in retirement.
15% on contributions, 13% on distributions.
15%-13% = 2% Traditional Wins

I can understand doing a backdoor Roth if you have already met your contribution limits for the traditional space as the costs are the same, but under no other circumstance can I see the point of contributing to a Roth first. Maybe for inheritance tax avoidance?

It seems that most of the Traditional vs Roth arguments I see online are based on marginal tax rates for contributions and distributions. The flaw there being that the distributions should be treated at the effective tax rate not the marginal.

Is my thinking above flawed in some major way that I am not seeing?

I've got three years left to contribute 17,500 to a Roth TSP space before I retire... after which I cannot because of income limits for the regular Roth IRA. Really want to know if I should take advantage of it while I can or continue with my regular TSP.


Agreed which is why my opinion is to ONLY get a Roth after all TIRA, 401k, etc space is used up - essentially a back door roth is preferable to straight taxable
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Re: Do Roth accounts always lose?

Postby bertilak » Sun Sep 01, 2013 12:59 pm

The Wizard wrote:
bertilak wrote:Can you elaborate on the underlined part? I thought "bracket" meant "marginal."

P.S. I am already at 15% even w/o the RMDs.

It has to do with the phase-in of SS taxation by the IRS, as a function of other income from various sources.
Low income folks have zero percent of their SS taxed.
Middling income folks have up to 50% of their SS taxed.
Higher income folks have up to 85% of their SS taxed.
So when you're in those ramp zones, another $10 of pension income also pushes a portion of SS income into a higher tax zone...

Got it -- thanks.
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Re: Do Roth accounts always lose?

Postby donall » Sun Sep 01, 2013 1:04 pm

nisiprius wrote:Mr. Senile here: as the days of the Required Minimum Distribution start to loom, I have to say that the simplicity of the Roth--just withdraw the money and spend it--looks better and better all the time. Nothing to do, nothing to think about, nothing to set aside for taxes, no worries about how taxable withdrawals from the IRA affect the taxability of Social Security...

...hmmmm, has anyone taken that into account in the discussion yet? I bet the online calculators don't. It's this innocent-looking form that has about nine different inequalities in it; if adjusted deductible is greater than table B if married filing jointly, then subtract net benefits from gross taxable after exemptions and enter the result on line 5 and hunt the treble, but not greater than the minimum of 15% of the combined ages of Mary and Ann when Mary was twice as old as Ann will be when the dominical letter falls after C, except in the words science, fancies, and glacier....

It is actually quite easy to fill out the form. What's really difficult is to figure out the moving parts and make a little chart of the relationship between pre-tax income and after-tax income.


I think this is the a great reason, simplicity. Maybe not so important now, but makes a big difference later on.
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Re: Do Roth accounts always lose?

Postby island » Sun Sep 01, 2013 2:05 pm

The Wizard wrote:
bertilak wrote:
SeattleCPA wrote:The upshot? Using a Roth should mostly be a bet that your marginal rate will rise during retirement.

What about the following consideration:

  • If one is already retired and gets most of one's income from SS and a DB pension, I think it is safe to assume the tax rate will not go down and those future RMDs will soon push one into a higher bracket. Converting to ROTH will reduce the RMDs.
  • I will only convert what I can without going into a higher bracket.
  • I don't need all (or even much) of the RMDs to meet expenses. I am creating the tax liability only because it is required.
  • The RMD proceeds will be reinvested in a taxable account where only dividends will be taxable, not whatever I withdraw. I will likely never withdraw any cap gains because any money I need will come directly from the RMDs that I already paid tax on.

This is almost exactly my case as well.
Once retired, the further you get into your 60's, the clearer the writing on the wall becomes...


We're also in the same boat. Don't anticipate needing RMDs for expenses. We've always saved, maxed out our 401ks, but only recently started to look at what that translates to when forced to withdraw. Yikes! We're mid 50's, still working and will probably have more income in retirement than we make now. Never anticipated that and what do we do about it? Trying to figure out the best way to reduce that tax hit...if it' even possible.
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Re: Do Roth accounts always lose?

Postby On the way » Sun Sep 01, 2013 3:28 pm

I too just started to look at taxes in retirement (see post Portfolio Advice under investing). I had always thought max out the 401k and found this is not nessarly true. My plan now is to reduce 401k contributions and start funding roths for my wife and I, however keeping my taxable income under $72,500 to stay in the 15% marginal bracket. Even with this, my potential RMD from the 401k will likley be too big, but I will look at moving some money from the 401k to the Roth at 59 1/2 and also look at delay taking ss until I reach 70.
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Re: Do Roth accounts always lose?

Postby monocle » Sun Sep 01, 2013 3:39 pm

ObliviousInvestor wrote:
SeattleCPA wrote:BTW, if you do your math right and the marginal rate both during your working years and during your retirement years is identical, you have a "six of one half a dozen of the other" situation.
[...]
When Roths first appeared, most financial advisors, accountants, mutual fund companies didn't seem to understand the math.

That darned commutative property of multiplication. It gets people every time. :|


I think this is where the flawed logic is from.

It doesn't work out this way. Lets assume a 25% marginal at both the contribution and the distribution phase and a 0% rate of return on the investment and just a one time 1000 dollar contribution.

Based on the commutative property of multiplication...
Roth: 1000 contribution = 1000 distribution - the 250 contribution tax = 750
Traditional: 1000 contribution = 1000 distribution - 250 distribution tax = 750

However... it doesn't work out like that.
The contribution tax is in fact 25%, however the distribution in the 25% tax bracket doesn't exist. The distribution is based on all sources of income and should be calculated at the effective tax rate, not the marginal bracket.
Roth: 1000 contribution = 1000 distribution - the 250 contribution tax = 750
Traditional 1000 contribution = 1000 distribution - 150 distribution tax (15% effective rate, even though we are in the 25% tax bracket) = 850
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Re: Do Roth accounts always lose?

Postby JW Nearly Retired » Sun Sep 01, 2013 4:31 pm

monocle wrote:Based on the commutative property of multiplication...
Roth: 1000 contribution = 1000 distribution - the 250 contribution tax = 750
Traditional: 1000 contribution = 1000 distribution - 250 distribution tax = 750

However... it doesn't work out like that.The contribution tax is in fact 25%, however the distribution in the 25% tax bracket doesn't exist. The distribution is based on all sources of income and should be calculated at the effective tax rate, not the marginal bracket.
Roth: 1000 contribution = 1000 distribution - the 250 contribution tax = 750
Traditional 1000 contribution = 1000 distribution - 150 distribution tax (15% effective rate, even though we are in the 25% tax bracket) = 850

Sorry, it does work out like that. The effective bracket is meaningless in investing. You have no dollar of income that is taxed at an effective bracket rate. Assuming you are not drawing SS, the first dollar to the last dollar of the income within the 25% marginal bracket is Federal taxed at 25%. Anywhere within the 25% bracket, $1000 of Roth income replacing $1000 in TIRA RMD income will save you exactly $250.

An exception is if you are straddling a marginal bracket boundary so the delta puts you into another bracket. That would favor the Roth more. The SS income taxation phase-in would make the TIRA income taxation situation even more progressive and also favor the Roth more.
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Re: Do Roth accounts always lose?

Postby ObliviousInvestor » Sun Sep 01, 2013 4:34 pm

monocle wrote:
ObliviousInvestor wrote:
SeattleCPA wrote:BTW, if you do your math right and the marginal rate both during your working years and during your retirement years is identical, you have a "six of one half a dozen of the other" situation.
[...]
When Roths first appeared, most financial advisors, accountants, mutual fund companies didn't seem to understand the math.

That darned commutative property of multiplication. It gets people every time. :|


I think this is where the flawed logic is from.

It doesn't work out this way. Lets assume a 25% marginal at both the contribution and the distribution phase and a 0% rate of return on the investment and just a one time 1000 dollar contribution.

Based on the commutative property of multiplication...
Roth: 1000 contribution = 1000 distribution - the 250 contribution tax = 750
Traditional: 1000 contribution = 1000 distribution - 250 distribution tax = 750

However... it doesn't work out like that.
The contribution tax is in fact 25%, however the distribution in the 25% tax bracket doesn't exist. The distribution is based on all sources of income and should be calculated at the effective tax rate, not the marginal bracket.
Roth: 1000 contribution = 1000 distribution - the 250 contribution tax = 750
Traditional 1000 contribution = 1000 distribution - 150 distribution tax (15% effective rate, even though we are in the 25% tax bracket) = 850

I disagree. I think analysis must be done at the margin, taking into account what you know so far about your retirement financial situation.

As a very basic example, imagine that I am one year away from retiring, I have no retirement savings, and I am ineligible for Social Security. I will, however, have a $30,000/year inflation-adjusted government pension. I have $1,000 that I'm considering contributing to a Roth or traditional IRA.

Assuming for the moment that I am eligible for a deduction for a contribution to a traditional IRA, what tax rates should I be comparing for the sake of making this decision?
1) My current effective tax rate to my future effective tax rate,
2) My current marginal tax rate to my future marginal tax rate,
3) My current effective tax rate to my future marginal tax rate, or
4) My current marginal tax rate to my future effective tax rate.

I think #2 is the only analysis that makes sense. My 0% and 10% tax brackets will be filled in retirement by my pension. The additional income from tax-deferred distributions will be taxed at 15%. Why would my effective tax rate be relevant for this decision?
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Re: Do Roth accounts always lose?

Postby kaneohe » Sun Sep 01, 2013 5:24 pm

I'm voting w/ the old dogs on this forum.........I mean the folks w/ the most posts. :happy ....jw and oi.........
Seems to me that if you're considering the consequences of an action, you be considering what happens with it and what happens without it.......the delta between the two is the consequence (more like marginal) . Taking an average or effective rate just seem to muddy this by smearing all the actions together.

Suppose you have filled out the 15% bracket w/ordinary income and in addition have some capital gains in the 25% bracket that are taxed at 15%. I'm guessing the effective rate is somewhat less than 15% since the ordinary income is taxed at 0, 10, 15%
and the CG at 15%. How much did the last bit of ordinary income cost you? Kind of depends.......suppose you did not take the CG until Dec 31 and were deciding whether to work or not get paid in early Dec. You decide to work and fill out the 15% bracket. Those earnings cost you 15% and the later CG cost you 15%.

Now reverse the order of those actions. You take the CG early in the year and in early Dec you have filled up the 15% bracket with wages and the CG. The CG is currently in the 15% bracket and is taxed at 0%. Again you are deciding to work or not get paid in early Dec. You decide to work........what is the consequence? Your earnings now push some or all of the CG into the 25% bracket where they are now taxed at 15%. Your earnings are also taxed at 15% so it is possible that by working a bit more you effectively got taxed at 30% on that extra income.

In the end, it is the same situation and same tax in both cases. However it seems to me that it is the last action (on the margin) that determines whether you want to take it or not since the consequences depend on that last marginal act.
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Re: Do Roth accounts always lose?

Postby monocle » Sun Sep 01, 2013 6:06 pm

kaneohe wrote:
monocle wrote:Here is an example of one my calculations...
Person in the current 25% tax bracket is putting into:
ROTH: 10,000
or putting into
TRADITIONAL: 12,500 (investing the tax savings)


I believe bsteiner pointed out in another thread that this probably should be:
Roth: 10,000
TIRA: 13,333 (roth is 75% of TIRA, not 80%, which actually helps your case)


Good catch. Thanks.
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Re: Do Roth accounts always lose?

Postby tetractys » Sun Sep 01, 2013 6:52 pm

The number one advantage of contributing to a Roth for me is that the tax free withdrawals are multi-generational. With the traditional that's not the case, and inheritor's end up stuck paying the benefactor's income tax. -- Tet
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Re: Do Roth accounts always lose?

Postby SC Hoosier » Sun Sep 01, 2013 7:22 pm

I realize that I am a outlier in this forum, but for my situation the tIRA cannot possibly win. My wife and I both work and have a household income of 34,000. We pay NO federal income taxes because we have 3 kids. I probably will work part time in retirement just to feel useful. So, if we make approximately $20,000 per year with some social security income, I'll be really glad that I chose a roth. I wouldn't get any tax reduction for contributing to a tIRA anyway. Later in life, with a higher income and no kids at home, it would be a good idea for me to start contributing to a tIRA so that I can reduce my current tax burden and have some different withdrawal options in retirement.

Thoughts?
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Re: Do Roth accounts always lose?

Postby SeattleCPA » Sun Sep 01, 2013 8:38 pm

tetractys wrote:The number one advantage of contributing to a Roth for me is that the tax free withdrawals are multi-generational. With the traditional that's not the case, and inheritor's end up stuck paying the benefactor's income tax. -- Tet


If you want to minimize your taxes, you should use a traditional IRA. (This makes your kids pay.)

If you want to minimize your kids taxes, you should use a Roth. (This makes you pay.)

If you want to minimize your family's taxes, you should have the person with the lowest marginal rate pay. (This saves your family taxes.)

BTW, I do think to echo (I think) JamesSFO's comments, that while 99% of this decision is about marginal rates that there ARE other minor factors. The ability to not take distributions and leave for heirs is worth something and another wrinkle. (I would say if you want to do this, you should prove the benefit mathematically just to make sure you're being rigorous.)
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