Why the Roth IRA Bias?
Why the Roth IRA Bias?
I'm puzzled by the apparent bias toward using Roth IRAs, given that the choice between traditional and Roth should be determined by each individual's tax situation. The bias is apparent, for example, in the wiki, which recommends contributing first to 401(k)/403(b) to maximize employer match, then to a Roth IRA, then back to 401/403. I would think the recommended second priority should be traditional or Roth IRA depending on whether or not you expect to be in a lower tax bracket when you retire. I don't mean to single out the wiki, as I see the same apparent bias in most recommendations in BH forum posts and elsewhere.
I understand the many benefits of a Roth; e.g., no RMDs, tax-free withdrawals, ability to withdraw contributions without penalty, etc. I also appreciate the Roth tax diversification benefit for someone making significant traditional 401/403 contributions. However, for someone who is unlikely to build significant wealth by retirement, and is likely to have a lower marginal tax rate in retirement, the current tax deduction of a traditional IRA may be a more significant benefit.
Some BH posters have written blog posts on planning to fill up the lower tax brackets in retirement (which is an excellent consideration), and use this as an argument to use traditional 401/403 plans rather than Roth 401/403 plans. Doesn't the same argument apply to using a traditional IRA rather than a Roth in some situations; e.g., if one doesn't have a 401/403 (or pension), or for whatever reasons is unlikely to have significant income in retirement?
For many, it's likely that withdrawals from traditional IRAs won't be taxed at all. My Mom and her husband paid no federal or state income taxes for 2009 (first full year of retirement) despite receiving very healthy social security payments. Although they didn't have to take an RMD in 2009, their unused 0% tax space was over $16,500, which I estimate will just about be filled in 2010 by RMD and portion of SS that may be taxable. People in this situation get the tax deduction on traditional IRA contributions, and pay no taxes on withdrawals, so with respect to income taxes, the traditional IRA is superior to the Roth.
So, just wondering if despite having researched this and analyzed it quite a bit, there's still something I'm missing.
Thanks,
Kevin M
- Edited to correct mis-statement about taking RMD in 2009.
I understand the many benefits of a Roth; e.g., no RMDs, tax-free withdrawals, ability to withdraw contributions without penalty, etc. I also appreciate the Roth tax diversification benefit for someone making significant traditional 401/403 contributions. However, for someone who is unlikely to build significant wealth by retirement, and is likely to have a lower marginal tax rate in retirement, the current tax deduction of a traditional IRA may be a more significant benefit.
Some BH posters have written blog posts on planning to fill up the lower tax brackets in retirement (which is an excellent consideration), and use this as an argument to use traditional 401/403 plans rather than Roth 401/403 plans. Doesn't the same argument apply to using a traditional IRA rather than a Roth in some situations; e.g., if one doesn't have a 401/403 (or pension), or for whatever reasons is unlikely to have significant income in retirement?
For many, it's likely that withdrawals from traditional IRAs won't be taxed at all. My Mom and her husband paid no federal or state income taxes for 2009 (first full year of retirement) despite receiving very healthy social security payments. Although they didn't have to take an RMD in 2009, their unused 0% tax space was over $16,500, which I estimate will just about be filled in 2010 by RMD and portion of SS that may be taxable. People in this situation get the tax deduction on traditional IRA contributions, and pay no taxes on withdrawals, so with respect to income taxes, the traditional IRA is superior to the Roth.
So, just wondering if despite having researched this and analyzed it quite a bit, there's still something I'm missing.
Thanks,
Kevin M
- Edited to correct mis-statement about taking RMD in 2009.
Last edited by Kevin M on Thu Oct 14, 2010 6:19 pm, edited 1 time in total.
Kevin: I don't think you are missing anything. In my time here I have come to the conclusion that many (certainly not all) posters don't fully analyze and understand their income tax situation, and they miss the likelihood - as you point out clearly - that they may be in a lower tax rate in retirement.
On top of this issue - which is always present - you have more froth this year because a) those with higher incomes can convert to a Roth for the first time, and b) those who convert in 2010 can spread the conversion income out over two years. I suppose the potential for tax rates to rise next year has also added to the froth.
Best wishes.
On top of this issue - which is always present - you have more froth this year because a) those with higher incomes can convert to a Roth for the first time, and b) those who convert in 2010 can spread the conversion income out over two years. I suppose the potential for tax rates to rise next year has also added to the froth.
Best wishes.
Andy
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Re: Why the Roth IRA Bias?
Kevin, The second priority is tricky. An investor who has decided that Traditional 401k contributions are best for their situation may come to the conclusion that Roth IRA contributions are better. If Trad 401k is better than Roth 401k, wouldn't it follow that Trad IRA be better than Roth IRA? Maybe not. Trad IRA may not be suitable if the taxpayer is not eligible to take the TradIRA tax deduction. If income does not allow IRA deduction but does allow Roth IRA contribution, Roth IRA contribution is the better option.Kevin M wrote:I would think the recommended second priority should be traditional or Roth IRA depending on whether or not you expect to be in a lower tax bracket when you retire. I
See this link to IRS Pub 590 Traditional IRAs. Limit if Covered By a Retirement Plan at work (Tables 1-2 and Tables 1-3):
http://www.irs.gov/publications/p590/ch ... 1000230467
Last edited by DSInvestor on Thu Oct 14, 2010 6:23 pm, edited 3 times in total.
- Taylor Larimore
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Investing priority after 410K match ?
Hi Kevin:
Nice catch.
In most cases, I would agree with you.I would think the recommended second priority (after the 401K match) should be traditional or Roth IRA depending on whether or not you expect to be in a lower tax bracket when you retire.
Nice catch.
"Simplicity is the master key to financial success." -- Jack Bogle
I think the bias, is in part, due to people wanting to be in a higher tax bracket at retirement (who wouldn't?), so they plan accordingly.
Myself, I hedge - I have a lot of traditional 401k money already, so the IRA money goes into a Roth. Who knows what bracket I will be in? Who knows the brackets will even be in 25 years? I suspect our tax burden will be higher, overall, but who knows if it will even be income tax? A split between the two types of plans seems reasonable.
Myself, I hedge - I have a lot of traditional 401k money already, so the IRA money goes into a Roth. Who knows what bracket I will be in? Who knows the brackets will even be in 25 years? I suspect our tax burden will be higher, overall, but who knows if it will even be income tax? A split between the two types of plans seems reasonable.
It takes a little more money. . .in the sense that it's after tax money. . .to fund a Roth IRA up front. But I like knowing that my responsibility to pay taxes is through after that. . .
"I would rather die with money, than live without it...." - Bogleheads member Ron |
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A time to EVALUATE your jitters https://www.bogleheads.org/forum/viewtopic.php?p=1139732#p1139732
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Re: Why the Roth IRA Bias?
Why wouldn't maxing the 401k be the second priority for that scenario?DSInvestor wrote:If income does not allow IRA deduction but does allow Roth IRA contribution, Roth IRA contribution is the better option.
Re: Why the Roth IRA Bias?
I think your right. Maybe it has something to do with qualitative aspects that make it difficult to look at just the numbers. For example:Kevin M wrote:I'm puzzled by the apparent bias toward using Roth IRAs, given that the choice between traditional and Roth should be determined by each individual's tax situation. The bias is apparent, for example, in the wiki, which recommends contributing first to 401(k)/403(b) to maximize employer match, then to a Roth IRA, then back to 401/403. I would think the recommended second priority should be traditional or Roth IRA depending on whether or not you expect to be in a lower tax bracket when you retire. I don't mean to single out the wiki, as I see the same apparent bias in most recommendations in BH forum posts and elsewhere.
With the Roth there is more potential for future growth, since the full contribution of the Roth remains tax sheltered. Your the owner, you've already paid your taxes, and your chunk is 100% from here on out.
The Traditional saves taxes up front; but income taxes have to be paid later on both the contribution and returns. Essentially you pay the custodial time and compounded costs--yuck--for whatever the government owned portion will end up as, according to the percentage of your income tax. Your the ???% partner doing 100% of the work.
If your taxes are lower by enough upon withdrawal than they were when you contributed, that could possibly make up for your expenditures in behalf of Uncle Sam; but if greater or equal, no way. So just how much is all that time and compounded cost you spent for Uncle Sam's portion worth to you anyway? You may never know.
Best regards, Tet
Re: Why the Roth IRA Bias?
DSInvestor, thanks for elaboration and clarification. I'm very familiar with Pub 590, and the various scenarios, which is why I suggest that it depends on the individual's tax situation. Perhaps rather than the qualifier being "lower tax bracket when you retire", it simply should've been "depending on your individual tax situation". I'm mainly thinking of people who are eligible for the traditional IRA tax deduction, and are likely to be in a lower tax bracket in retirement. I'm concerned about the blanket recommendation to use a Roth IRA when a traditional IRA is likely to provide greater total after tax income for certain individuals.DSInvestor wrote:Kevin, The second priority is tricky. An investor who has decided that Traditional 401k contributions are best for their situation may come to the conclusion that Roth IRA contributions are better. If Trad 401k is better than Roth 401k, wouldn't it follow that Trad IRA be better than Roth IRA? Maybe not. Trad IRA may not be suitable if the taxpayer is not eligible to take the TradIRA tax deduction. If income does not allow IRA deduction but does allow Roth IRA contribution, Roth IRA contribution is the better option.Kevin M wrote:I would think the recommended second priority should be traditional or Roth IRA depending on whether or not you expect to be in a lower tax bracket when you retire. I
See this link to IRS Pub 590 Traditional IRAs. Limit if Covered By a Retirement Plan at work (Tables 1-2 and Tables 1-3):
http://www.irs.gov/publications/p590/ch ... 1000230467
Thanks tfb. I'm thinking more about people who don't come close to maxing out a 401k; maybe who don't even have access to a 401k. Even if only in 10% or 15% bracket now, isn't it better to take the $500-$900 deduction now (assuming you max the IRA) considering that you may well be in the 0% bracket in retirement? Or even if not 0% marginal, have significant 0% space left to fill? For people in this situation, doesn't your "fill the low tax brackets" argument for traditional 401k apply to traditional IRA as well?tfb wrote:What to do 2nd doesn't matter if you max out both anyway. If someone isn't maxing out both, that person likely isn't in a high bracket now. 401k funds are usually bad. Both of these factors push toward Roth IRA a little.
Agree that 401k funds are often bad (best options for one of my daughters are active funds with >1.25% ER), which is a reason to direct the first $5,000 (or $6,000) to some type of IRA. Still, whether Roth or traditional depends on tax analysis for the individual, no? Still don't get why you think this factor "pushes toward a Roth" in particular. This is a perfect example of the bias I'm still trying to understand.
I agree that someone making significant 401k/403b contributions probably is better off with a Roth, since I'm persuaded by the tax diversification arguments, and such a person is more likely to be in a higher tax bracket in retirement than someone who is not making significant 401k contributions (and has no pension).
If you have a 401k at work, then the IRS income limits for being able to deduct Ira contributions is much lower than to contribute to a Roth. For a single filer deductibility starts to phase out at $56,000 and for married filing jointly at $89,000 for 2010. Roth contribution limits go up to $105,000 and $166,000. So in practice, most of the time anyone with enough income to contribute enough to max their 401k has too much income to deduct their traditional Ira contributions. Additionally, the marginal rates on income tax for incomes under $56,000 and $89,000 are fairly low, so initial deductibility is less valuable to people actually able to deduct traditional iras. Lastly, there is something to be said for the benefits having both Roth and 401k (pre and post tax accounts) adds to one's future through tax diversity.
Re: Why the Roth IRA Bias?
Cool.tetractys wrote:I think your right. Maybe it has something to do with qualitative aspects that make it difficult to look at just the numbers.Kevin M wrote:I'm puzzled by the apparent bias toward using Roth IRAs, given that the choice between traditional and Roth should be determined by each individual's tax situation. The bias is apparent, for example, in the wiki, which recommends contributing first to 401(k)/403(b) to maximize employer match, then to a Roth IRA, then back to 401/403. I would think the recommended second priority should be traditional or Roth IRA depending on whether or not you expect to be in a lower tax bracket when you retire. I don't mean to single out the wiki, as I see the same apparent bias in most recommendations in BH forum posts and elsewhere.
Ah, but in the scenarios I'm thinking about, a good chunk of your traditional IRA distributions, if not all, are taxed at 0% on withdrawal, and to that extent, the Roth has no advantage.tetractys wrote: With the Roth there is more potential for future growth, since the full contribution of the Roth remains tax sheltered. Your the owner, you've already paid your taxes, and your chunk is 100% from here on out.
I think this is basically the same point, and the response is the same.tetractys wrote: The Traditional saves taxes up front; but income taxes have to be paid later on both the contribution and returns. Essentially you pay the custodial time and compounded costs--yuck--for whatever the government owned portion will end up as, according to the percentage of your income tax. Your the ???% partner doing 100% of the work.
True, but if you pay 0% on withdrawal, then you've made no expenditures for Uncle Sam.tetractys wrote: If your taxes are lower by enough upon withdrawal than they were when you contributed, that could possibly make up for your expenditures in behalf of Uncle Sam; but if greater or equal, no way. So just how much is all that time and compounded cost you spent for Uncle Sam's portion worth to you anyway? You may never know.
Thanks,
Kevin
Re: Why the Roth IRA Bias?
You're absolutely right, and I have no argument with you. As I stated in my original post, just putting forth possible qualitative reasons for the bias. -- TetKevin M wrote:Cool.tetractys wrote:I think your right. Maybe it has something to do with qualitative aspects that make it difficult to look at just the numbers.Kevin M wrote:I'm puzzled by the apparent bias toward using Roth IRAs, given that the choice between traditional and Roth should be determined by each individual's tax situation. The bias is apparent, for example, in the wiki, which recommends contributing first to 401(k)/403(b) to maximize employer match, then to a Roth IRA, then back to 401/403. I would think the recommended second priority should be traditional or Roth IRA depending on whether or not you expect to be in a lower tax bracket when you retire. I don't mean to single out the wiki, as I see the same apparent bias in most recommendations in BH forum posts and elsewhere.
Ah, but in the scenarios I'm thinking about, a good chunk of your traditional IRA distributions, if not all, are taxed at 0% on withdrawal, and to that extent, the Roth has no advantage.tetractys wrote: With the Roth there is more potential for future growth, since the full contribution of the Roth remains tax sheltered. Your the owner, you've already paid your taxes, and your chunk is 100% from here on out.
I think this is basically the same point, and the response is the same.tetractys wrote: The Traditional saves taxes up front; but income taxes have to be paid later on both the contribution and returns. Essentially you pay the custodial time and compounded costs--yuck--for whatever the government owned portion will end up as, according to the percentage of your income tax. Your the ???% partner doing 100% of the work.
True, but if you pay 0% on withdrawal, then you've made no expenditures for Uncle Sam.tetractys wrote: If your taxes are lower by enough upon withdrawal than they were when you contributed, that could possibly make up for your expenditures in behalf of Uncle Sam; but if greater or equal, no way. So just how much is all that time and compounded cost you spent for Uncle Sam's portion worth to you anyway? You may never know.
Last edited by tetractys on Thu Oct 14, 2010 7:56 pm, edited 1 time in total.
Can't argue with most of this. I was never eligible for a Roth when working, so had to live with non-deductible IRA on top of maxing out 401(k). Roth for someone who is eligible, but isn't eligible for traditional IRA deduction, is a no brainer. However, none of these is the scenario I'm addressing.RabbMD wrote:If you have a 401k at work, then the IRS income limits for being able to deduct Ira contributions is much lower than to contribute to a Roth. For a single filer deductibility starts to phase out at $56,000 and for married filing jointly at $89,000 for 2010. Roth contribution limits go up to $105,000 and $166,000. So in practice, most of the time anyone with enough income to contribute enough to max their 401k has too much income to deduct their traditional Ira contributions. Additionally, the marginal rates on income tax for incomes under $56,000 and $89,000 are fairly low, so initial deductibility is less valuable to people actually able to deduct traditional iras. Lastly, there is something to be said for the benefits having both Roth and 401k (pre and post tax accounts) adds to one's future through tax diversity.
The only part I take issue with is saying that "the initial deductibility is less valuable to people actually able to deduct traditional iras". Less valuable than what? Isn't saving $500 or more in federal taxes (and maybe some more in state taxes) and perhaps not paying any taxes when taking withdrawals a sensible thing to do?
I am with you, have both. I am not selling T-IRA for R-IRA but I will contribute to R-IRA with new money. I know my tax bracket will be higher in retirement if I continue to work next 30 years. National debt is going up and up, tax will likely go up too.happymob wrote:I think the bias, is in part, due to people wanting to be in a higher tax bracket at retirement (who wouldn't?), so they plan accordingly.
Myself, I hedge - I have a lot of traditional 401k money already, so the IRA money goes into a Roth. Who knows what bracket I will be in? Who knows the brackets will even be in 25 years? I suspect our tax burden will be higher, overall, but who knows if it will even be income tax? A split between the two types of plans seems reasonable.
Re: Why the Roth IRA Bias?
Ok, I think I get your point now, and it's precisely what I want to explore. People know that Roth IRA withdrawals are tax-free, and base their decisions or recommendations based on this, perhaps without actually doing a tax analysis for their particular situation.tetractys wrote: You're absolutely right. And I have no argument with you--just putting forth possible qualitative reasons for the bias. -- Tet
Part of my motivation in posting this is that a friend recently told me that he preferred the Roth because it was tax-free, but in looking into his situation a little, it appears that there's a good chance he might pay 0% on withdrawals from a traditional IRA (he certainly would under anything close to current tax laws), and he is eligible for the full traditional IRA deduction. This would mean same tax benefit on the back end, and more tax benefit on the front end (traditional vs. Roth).
Kevin, I now see your point. For people that make under $56,000 or $89,000, that already contribute to the match of a 401k or do not have a 401k (yes the income limits do go up for people that can't contribute to a 401k), have a poor 401k at work with high expense ratios or despite their relatively low agis are already contributing the max to their iras, and expect to in a lower tax bracket at retirement a traditional Ira instead of a Roth could make sense. But that is a lot of Ifs and assumptions.
What I meant by less valuable, is with the uncertainty of future tax rates and laws, the $200-$500 (4-10% marginal rate on that agi) saved intially in taxes with contribution becomes in my opinion less valuable than the possibility government not taxing future Ira withdrawals at higher rates than they are currently.
Add in the benefits of tax diversification and different rules for Roth Ira contribution withdrawals (being able to take contributions out penalty free and other penalty free withdrawal circumstances pre 59.5), and a vast majority of people are likely better off in roths after 401k matchs. But yes, there could be exceptions based on personal tax situations.
What I meant by less valuable, is with the uncertainty of future tax rates and laws, the $200-$500 (4-10% marginal rate on that agi) saved intially in taxes with contribution becomes in my opinion less valuable than the possibility government not taxing future Ira withdrawals at higher rates than they are currently.
Add in the benefits of tax diversification and different rules for Roth Ira contribution withdrawals (being able to take contributions out penalty free and other penalty free withdrawal circumstances pre 59.5), and a vast majority of people are likely better off in roths after 401k matchs. But yes, there could be exceptions based on personal tax situations.
Re: Why the Roth IRA Bias?
It's hard to say. Nobody knows what future tax rates will be. For a Roth there is the hedging effect against future tax hikes. And I suppose one could say that the up front taxes are the premium one has to pay for that hedge. And that's also a hedge against RMDs. The idea of never being required to withdraw must be worth something, even though it's purely situational as well.Kevin M wrote:Ok, I think I get your point now, and it's precisely what I want to explore. People know that Roth IRA withdrawals are tax-free, and base their decisions or recommendations based on this, perhaps without actually doing a tax analysis for their particular situation.tetractys wrote: You're absolutely right. And I have no argument with you--just putting forth possible qualitative reasons for the bias. -- Tet
Part of my motivation in posting this is that a friend recently told me that he preferred the Roth because it was tax-free, but in looking into his situation a little, it appears that there's a good chance he might pay 0% on withdrawals from a traditional IRA (he certainly would under anything close to current tax laws), and he is eligible for the full traditional IRA deduction. This would mean same tax benefit on the back end, and more tax benefit on the front end (traditional vs. Roth).
But yes, all in all Traditional and Roth should be considered equally. -- Tet
of course it does. if a traditional Ira deduction is available, all the reasons against Roth 401k apply to Roth Ira as well. I said those two factors push toward Roth a little, just a little. remember people on this board on average have higher income than the scenario you are thinking of. there's that bias because a traditional ira deduction simply isn't available to most posters. you are not missing anything.Kevin M wrote:Thanks tfb. I'm thinking more about people who don't come close to maxing out a 401k; maybe who don't even have access to a 401k. Even if only in 10% or 15% bracket now, isn't it better to take the $500-$900 deduction now (assuming you max the IRA) considering that you may well be in the 0% bracket in retirement? Or even if not 0% marginal, have significant 0% space left to fill? For people in this situation, doesn't your "fill the low tax brackets" argument for traditional 401k apply to traditional IRA as well?tfb wrote:What to do 2nd doesn't matter if you max out both anyway. If someone isn't maxing out both, that person likely isn't in a high bracket now. 401k funds are usually bad. Both of these factors push toward Roth IRA a little.
Harry Sit has left the forums.
Just the simplicity of Roths in retirement is beaufitful,not having to deal with uncle sam..he is paid off, is worth it enough even if you just end up breaking even on taxes roth or non roth..
Not having Roths count as income(or the compound interest they bring you) in retirement is way underestimated the way the system works..You dont have to figure out all the scenario's of will I not qualify for this medical cutoff if I have this amount of income or take out this amount or will I have to pay higher SS taxes if I take out this amount this year in retirement.. etc..
my parents are retired and so many things are income based in retirement,its either a cut off income amount to qualify or a certain income will knock out of eligibilty..etc..
Not having Roths count as income(or the compound interest they bring you) in retirement is way underestimated the way the system works..You dont have to figure out all the scenario's of will I not qualify for this medical cutoff if I have this amount of income or take out this amount or will I have to pay higher SS taxes if I take out this amount this year in retirement.. etc..
my parents are retired and so many things are income based in retirement,its either a cut off income amount to qualify or a certain income will knock out of eligibilty..etc..
I think for most young single people, Roth's make sense. The cutoff is ~$100k which seems fairly sensible. Starting out I think most young people make between $40-80k, seems like a fairly decent estimate at the retirement withdrawal. Of course I have not done the calculations but just off hand it does not seem to be terrible broad advice to get a Roth.
A lot of the problem stems from erroneous analysis that occurred many years in the past and has been perpetuated mainly because of the unfortunate use of the terms "tax deferred" and "tax free" which imply a distinction that is not real.
Current consensus is that the tax rate then and now are the controlling factors. (Assuming the elimination of special cases like inheritance.) However there is virtually no consensus on what/how to determine tax rates. I think there is a generational bias at play. People with fixed pensions (and social security) as a base look at their IRA's as add on's and therefore use incremental tax rates in their calculations. Younger people without fixed pensions (and SS expectations) think of the IRA as their base and therefore use average tax rates in their calculations. The bias occurs because it is difficult to see the other side because people are too familiar with their own situation.
Current consensus is that the tax rate then and now are the controlling factors. (Assuming the elimination of special cases like inheritance.) However there is virtually no consensus on what/how to determine tax rates. I think there is a generational bias at play. People with fixed pensions (and social security) as a base look at their IRA's as add on's and therefore use incremental tax rates in their calculations. Younger people without fixed pensions (and SS expectations) think of the IRA as their base and therefore use average tax rates in their calculations. The bias occurs because it is difficult to see the other side because people are too familiar with their own situation.
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.
The rule of thumb in the Wiki is one of those attempts to grab the essential points of a situation for stupid-easy appreciation of the issues. Your concern with it has been pointed out many times.
Like all rules of thumb one should not follow it until one understands why it might usually apply and when it might not apply. Once that is accomplished, having a rule of thumb is superfluous.
I hate rules of thumb.
Like all rules of thumb one should not follow it until one understands why it might usually apply and when it might not apply. Once that is accomplished, having a rule of thumb is superfluous.
I hate rules of thumb.
One of interesting things that comes up with Roths for example is the town where I live just built a big luxury apartment complex(about 2000 a month market price)..it got everything,game room,water views,gym etc... 20% of that has to be made available under law to a combo of senior/low cost housing,the cutoff amount under the law is $29,000 a year in income..anything over that and your out.
Roth income is heck of way around that..it does not count as income..You could have for example have a senior with 500K in a Roth earning 20K a year in compound interest and maybe 7k a year in his own taxable income..who could qualify...and you could have another senior with $0 money in the bank earning 31K in combined pension,social security total and he is out of luck...
Roth income is heck of way around that..it does not count as income..You could have for example have a senior with 500K in a Roth earning 20K a year in compound interest and maybe 7k a year in his own taxable income..who could qualify...and you could have another senior with $0 money in the bank earning 31K in combined pension,social security total and he is out of luck...
Last edited by jack1719 on Fri Oct 15, 2010 11:49 am, edited 1 time in total.
You've got the right idea, but that's still not correct. Let's say you retire and every year from then forward you're in the 25% marginal bracket but pay 15% on average after deductions, etc. Your rule would suggest a tIRA at 20% would be good, when in fact it's bad. Marginal retirement savings comes out at your marginal income tax rate in some year during retirement. What you really should compare is your marginal rate now to the minimum of your expected marginal rates for each year during retirement.ladders11 wrote:I think one big error is made frequently when people compare tax rates. People should be comparing their marginal tax rate now with their average tax rate in retirement. Your Traditional IRA deduction comes off the top, whereas the income from it during retirement is just income.
A mixture is provably worse in expectation to any mixture, except in the case where your tax rates are the same and then nothing matters. Holding a mixture is a lower risk approach, but one that costs you money in expectation to the extent you allocate some retirement savings to the "probably wrong" IRA type given your personal tax situation. Reducing risk is fine, but at what price? It's like buying insurance - make sure you know what the premiums are before you sign up.EO 11110 wrote:my theory: mixture is superior to either/or.
My specific case:
Quit job Dec 29, 2006, at age 52. Was maxing out Roth and 401K (in approx 30% fed + high-tax state). Rolled over $180K to Vanguard tIRA.
Lived off savings for 3 yrs, so in $0 tax bracket, converted to Roth to top of 15% bracket each year (with no state taxes due).
Started taking (early) pension pymts in Aug 2009, so this yr (2010) was only able to convert $13k to Roth. But now only have $92k left to convert.
Will continue to convert to Roth (filling up to the 15% bracket, approx $13k yr) till age 62 (in 5 yrs)
Will start early SS at age 62 and have very little left in tIRA at that point (maybe $30+k??). Will slowly empty tIRA in most tax-efficient way to ease my yearly tax bills as much as possible.
My pension AND SS (if it's still around when I get to 62?) should put me around the top of the 15% bracket and any extra income from tIRA deductions should have little impact (which I should be able to control fairly well)
Hopefully tIRA will be at $0 long before RMDs kick in (if I even live that long) :lol:
Quit job Dec 29, 2006, at age 52. Was maxing out Roth and 401K (in approx 30% fed + high-tax state). Rolled over $180K to Vanguard tIRA.
Lived off savings for 3 yrs, so in $0 tax bracket, converted to Roth to top of 15% bracket each year (with no state taxes due).
Started taking (early) pension pymts in Aug 2009, so this yr (2010) was only able to convert $13k to Roth. But now only have $92k left to convert.
Will continue to convert to Roth (filling up to the 15% bracket, approx $13k yr) till age 62 (in 5 yrs)
Will start early SS at age 62 and have very little left in tIRA at that point (maybe $30+k??). Will slowly empty tIRA in most tax-efficient way to ease my yearly tax bills as much as possible.
My pension AND SS (if it's still around when I get to 62?) should put me around the top of the 15% bracket and any extra income from tIRA deductions should have little impact (which I should be able to control fairly well)
Hopefully tIRA will be at $0 long before RMDs kick in (if I even live that long) :lol:
Last edited by theac on Fri Oct 15, 2010 12:32 pm, edited 3 times in total.
"We keep you alive to serve this ship. Row well...and live." Ben Hur...and The Taxman! hahaha (a George Harrison song)
all great points. the risk cut is the benefit i'm after - in addition to the ability to manage taxable income. if everything goes right a great majority of pretax income will be hit at the poverty tax ratexerty24 wrote:A mixture is provably worse in expectation to any mixture, except in the case where your tax rates are the same and then nothing matters. Holding a mixture is a lower risk approach, but one that costs you money in expectation to the extent you allocate some retirement savings to the "probably wrong" IRA type given your personal tax situation. Reducing risk is fine, but at what price? It's like buying insurance - make sure you know what the premiums are before you sign up.EO 11110 wrote:my theory: mixture is superior to either/or.
The highest tax bracket in 2010 may be lower than the lowest tax bracket in 2040.
Tax diversification.
Also, if you need to remove contributions for an emergency, you can do so with a Roth, penalty free. Not so with a traditional IRA/401k. This is important because some people may not be able to contribute to any tax-shelter without having an adequate liquid emergency fund. One can keep a portion or totality of the emergency fund in a Roth IRA, counting contributions are liquid. This would be for someone who would otherwise need to forgo IRA contributions in a given tax year, due to not enough savings to cover both an emergency fund and IRA contributions.
Further, a Roth IRA lets one shield more assets than a T-IRA comparative to identical contribution limits. A Roth IRA, in a 25% tax bracket, allows one to shield $6700 in gross income as compared to $5k in a T-IRA. This is because you pay the taxes now and effectively shield the taxes as well. If you contribute $5k to a T-IRA you only see $4k after taxes when you eventually retire. If you contribute $5k to a Roth you get all $5k back.
The alternative would be to invest the $1700 in a taxable account, contribute $5k to a T-IRA, and pay taxes on the $1700 forever. And then only see $4k on the T-IRA when you get it out.
Finally, and I think this is most important, it's not possible to contribute to a Roth IRA if you are in the highest tax bracket. I believe the cutoff for Roth contributions is about $110k/year income, which would place you in the middle of all the tax brackets (28%). So it really is a moot point to describe whether someone in the 39% bracket should consider a Roth contribution, as no direct means of contribution are allowable.
Tax diversification.
Also, if you need to remove contributions for an emergency, you can do so with a Roth, penalty free. Not so with a traditional IRA/401k. This is important because some people may not be able to contribute to any tax-shelter without having an adequate liquid emergency fund. One can keep a portion or totality of the emergency fund in a Roth IRA, counting contributions are liquid. This would be for someone who would otherwise need to forgo IRA contributions in a given tax year, due to not enough savings to cover both an emergency fund and IRA contributions.
Further, a Roth IRA lets one shield more assets than a T-IRA comparative to identical contribution limits. A Roth IRA, in a 25% tax bracket, allows one to shield $6700 in gross income as compared to $5k in a T-IRA. This is because you pay the taxes now and effectively shield the taxes as well. If you contribute $5k to a T-IRA you only see $4k after taxes when you eventually retire. If you contribute $5k to a Roth you get all $5k back.
The alternative would be to invest the $1700 in a taxable account, contribute $5k to a T-IRA, and pay taxes on the $1700 forever. And then only see $4k on the T-IRA when you get it out.
Finally, and I think this is most important, it's not possible to contribute to a Roth IRA if you are in the highest tax bracket. I believe the cutoff for Roth contributions is about $110k/year income, which would place you in the middle of all the tax brackets (28%). So it really is a moot point to describe whether someone in the 39% bracket should consider a Roth contribution, as no direct means of contribution are allowable.
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The taxes that you will pay on IRA withdrawals will depend on the composition of your income in retirement. You'd really need to find the base tax for all income excluding IRA withdrawal and compare that to the tax for all income including IRA withdrawal. The difference in those two tax numbers will be the average tax for IRA withdrawal. If you do this type of calculation, you will be taking some special cases into consideration:
1. Current tax rules give preferential treatment to Qualified Dividend Income and Long Term capital gains. IRA withdrawals increase AGI which may cause some QDI and LTCG may be taxed at 15% instead of 0%.
2. Withdrawals from Traditional IRA may increase AGI to a level that triggers taxation of Social Security benefits. This could significantly increase the average tax rate of those IRA withdrawals until income rises to a level that 85% of social security benefits are taxed. Here's a link to a social security page "Taxes and your Social Security benefits":
http://www.ssa.gov/planners/taxes.htm
Roth IRA withdrawals will not increase AGI and thus will not affect the taxation of QDI/LTCG and Social Security benefits.
Tax software is great for these kinds of scenarios which involve some tricky tax rules.
1. Current tax rules give preferential treatment to Qualified Dividend Income and Long Term capital gains. IRA withdrawals increase AGI which may cause some QDI and LTCG may be taxed at 15% instead of 0%.
2. Withdrawals from Traditional IRA may increase AGI to a level that triggers taxation of Social Security benefits. This could significantly increase the average tax rate of those IRA withdrawals until income rises to a level that 85% of social security benefits are taxed. Here's a link to a social security page "Taxes and your Social Security benefits":
http://www.ssa.gov/planners/taxes.htm
Roth IRA withdrawals will not increase AGI and thus will not affect the taxation of QDI/LTCG and Social Security benefits.
Tax software is great for these kinds of scenarios which involve some tricky tax rules.
This covers the main reason I'm knocking down the balance in my tIRA as much as possible before I start SS at age 62.DSInvestor wrote: Withdrawals from Traditional IRA may increase AGI to a level that triggers taxation of Social Security benefits. This could significantly increase the average tax rate of those IRA withdrawals until income rises to a level that 85% of social security benefits are taxed. Here's a link to a social security page "Taxes and your Social Security benefits":
Roth IRA withdrawals will not increase AGI and thus will not affect the taxation of QDI/LTCG and Social Security benefits.
"We keep you alive to serve this ship. Row well...and live." Ben Hur...and The Taxman! hahaha (a George Harrison song)
If you have a taxable account with after-tax funds, you have virtually all of the benefits of tax diversification. You will be able to "manage" your tax rate by using the taxable funds to keep from bursting into the next marginal tax rate. To the extent that your assets are highly appreciated and to the extent that the capital gains tax rate is high, this benefit is somewhat diminished.Febreze wrote: Tax diversification.
I would recommend that any individual with a taxable account ignore the tax diversification aspect of the Roth conversion. Focus 100% on the two tax rates in the analysis.
Best wishes.
Andy
You're talking equities, like stocks. But I'm probably 70+% bond funds, (almost 100% of it in Total Bond Index).Wagnerjb wrote:If you have a taxable account with after-tax funds, you have virtually all of the benefits of tax diversification. You will be able to "manage" your tax rate by using the taxable funds to keep from bursting into the next marginal tax rate. To the extent that your assets are highly appreciated and to the extent that the capital gains tax rate is high, this benefit is somewhat diminished.Febreze wrote: Tax diversification.
I would recommend that any individual with a taxable account ignore the tax diversification aspect of the Roth conversion. Focus 100% on the two tax rates in the analysis.
Best wishes.
I believe holding THAT in a taxable account would not be very smart in my case. But in my Roth, they sit very well.
Last edited by theac on Fri Oct 15, 2010 1:27 pm, edited 1 time in total.
"We keep you alive to serve this ship. Row well...and live." Ben Hur...and The Taxman! hahaha (a George Harrison song)
I subscribe to the hedge theory as well. I have no idea what the state of taxes will be when I retire, so I max out my work tax-deferred retirement plan and a Roth IRA to try to diversify my tax burden a bit. Either way, contribution limits have skewed my hedging in favor of the tax-deferred accounts anyway.happymob wrote:Myself, I hedge - I have a lot of traditional 401k money already, so the IRA money goes into a Roth. Who knows what bracket I will be in? Who knows the brackets will even be in 25 years? I suspect our tax burden will be higher, overall, but who knows if it will even be income tax? A split between the two types of plans seems reasonable.
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So your example validates Kevin's thesis: that it may be possible to withdraw (=convert) tIRA funds at lower tax rates in retirement.theac wrote:Quit job Dec 29, 2006, at age 52. Lived off savings for 3 yrs, so in 0% tax bracket, converted to Roth to top of 15% bracket each year (with no state taxes due).
OK, Buff, we can agree that if you execute on both the 2nd and 3rd priorities it doesn't matter which came 2ndtfb wrote:What to do 2nd doesn't matter if you max out both anyway.
But if you have a retirement pension,you already know the bottom to middle tax brackets are gonna be taken up in retirement from that..
with a pension its better to tilt toward Roth..70/30 or something..Your bottom tax rungs are already filled and taken for rest of life..
unless you do like poster above...retire early before you can collect pension...live off savings from converted taxable IRA/401K..for several years to work it off under the lowest brackets possible..I have thought about that strategy numerous times...the vast majority of people its very tough to retire at 50 or 52 years old to pull off that move...etc...
I'm gonna have a full pension at 55 I could retire from and a taxable 401K and IRA..same boat as guy above..
with a pension its better to tilt toward Roth..70/30 or something..Your bottom tax rungs are already filled and taken for rest of life..
unless you do like poster above...retire early before you can collect pension...live off savings from converted taxable IRA/401K..for several years to work it off under the lowest brackets possible..I have thought about that strategy numerous times...the vast majority of people its very tough to retire at 50 or 52 years old to pull off that move...etc...
I'm gonna have a full pension at 55 I could retire from and a taxable 401K and IRA..same boat as guy above..
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RabbMD wrote:a vast majority of people are likely better off in roths after 401k matchs
While we're making comprehensively researched statistical conclusions, I'll add that a vast majority of bogleheads appear to be retiring early, without pensions, and with flexibility on when to start SS. Another vast majority (I like to think of two vast majorities sharing a bus seat) are drawing down their tIRAs in their nursing home years (they don't post much here, but I know they're out there, and vast), when their deductible medical expenses will put them in the 0% bracket.jack1719 wrote:the vast majority of people its very tough to retire at 50 or 52 years old to pull off that move
I think DSInvestor had it right when he said:
DSInvestor wrote:The second priority is tricky.
Thats a pretty important point I had mentioned a bit earlier..Roths dont count toward anything or trigger anything in retirement..DSInvestor wrote:The taxes that you will pay on IRA withdrawals will depend on the composition of your income in retirement. You'd really need to find the base tax for all income excluding IRA withdrawal and compare that to the tax for all income including IRA withdrawal. The difference in those two tax numbers will be the average tax for IRA withdrawal. If you do this type of calculation, you will be taking some special cases into consideration:
1. Current tax rules give preferential treatment to Qualified Dividend Income and Long Term capital gains. IRA withdrawals increase AGI which may cause some QDI and LTCG may be taxed at 15% instead of 0%.
2. Withdrawals from Traditional IRA may increase AGI to a level that triggers taxation of Social Security benefits. This could significantly increase the average tax rate of those IRA withdrawals until income rises to a level that 85% of social security benefits are taxed. Here's a link to a social security page "Taxes and your Social Security benefits":
http://www.ssa.gov/planners/taxes.htm
Roth IRA withdrawals will not increase AGI and thus will not affect the taxation of QDI/LTCG and Social Security benefits.
Tax software is great for these kinds of scenarios which involve some tricky tax rules.
- ruralavalon
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True, but difficult to apply in practice. I am 65 and will retire soon, so I find it easy to estimate my tax bracket in the early years of retirement.Kevin M wrote:I would think the recommended second priority should be traditional or Roth IRA depending on whether or not you expect to be in a lower tax bracket when you retire.
But most asking advice here are in their 20s, 30s or 40s, and will not retire for 20 - 40 more years. After retiring, most will live another 20 - 30 years. No one knows what the tax brackets will be then, much less do they know which of those unknown brackets they will be in. So this cannot be made into a simple problem of tax arithmetic.
Beyond that the decision is impacted by -- 1) poor fund choices or high expense ratios in 401ks; (2) The greater flexibility in pre-retirement withdrawals from Roth IRAs; (3) the post- retirement flexibility you get from having some money in a Roth which you can withdraw without adding any tax liability; (4) the benefits to survivors of Roth IRAs.
Last edited by ruralavalon on Fri Oct 15, 2010 2:42 pm, edited 4 times in total.
"Everything should be as simple as it is, but not simpler." - Albert Einstein |
Wiki article link: Bogleheads® investment philosophy
OP point is valid, but the whole point of 401K to match, Roth, max 401K is to make a complicated scenario easy for people who are struggling with investing decisions. There is no easy way to present info that makes the case for the best possible scenario for everyone's situation. Practicality dictates that the Roth gets the second spot in investing order.
Also, as pointed out by other posters, there are some additional perks, penalty free return of deposit, which makes the Roth a possible emergency fund, passing to heirs tax-free, unlike the 401k and trad IRA's and the ability to manipulate income to avoid taxation in retirement years.
Unless you have a 401K roth, or do a LOT of conversion, you are never going to get a serious amount of money in your Roth anyhow. Roth is a great tool, but a small one in the retirement handbag. If it's not the right tool for you, you will realize it quickly enough to quit using it before major harm is done.
Also, as pointed out by other posters, there are some additional perks, penalty free return of deposit, which makes the Roth a possible emergency fund, passing to heirs tax-free, unlike the 401k and trad IRA's and the ability to manipulate income to avoid taxation in retirement years.
Unless you have a 401K roth, or do a LOT of conversion, you are never going to get a serious amount of money in your Roth anyhow. Roth is a great tool, but a small one in the retirement handbag. If it's not the right tool for you, you will realize it quickly enough to quit using it before major harm is done.
- Mister Whale
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Wow. That's so simple, and yet I never thought of that. Thanks.ladders11 wrote:I think one big error is made frequently when people compare tax rates. People should be comparing their marginal tax rate now with their average tax rate in retirement. Your Traditional IRA deduction comes off the top, whereas the income from it during retirement is just income.
If you have ANY taxable account at all, why aren't equities in it? I certainly understand the preference to place fixed income into an IRA. But if you have any taxable account at all, you should be able to gain the tax diversification benefits.theac wrote:You're talking equities, like stocks. But I'm probably 70+% bond funds, (almost 100% of it in Total Bond Index).
I believe holding THAT in a taxable account would not be very smart in my case. But in my Roth, they sit very well.
Best wishes.
Andy
A different way to put it is that one should simply compute total tax cost and compare that result between two scenarios rather than trying to do mental accounting of tax rates.Jack90210 wrote:Wow. That's so simple, and yet I never thought of that. Thanks.ladders11 wrote:I think one big error is made frequently when people compare tax rates. People should be comparing their marginal tax rate now with their average tax rate in retirement. Your Traditional IRA deduction comes off the top, whereas the income from it during retirement is just income.
The algorithm for computing taxes does not produce an output from any meaningful definition of a single tax rate. Various sorts of tax rates can be computed as dependent results from the output of the tax cost,however. Marginal tax rate in particular is only defined within the context of comparing between two scenarios and is not a rate that is used in computing taxes. In certain simplified instances the marginal tax rate can come out to be the same number as one of the tax bracket rates, but that is not a general result. I would not in general assess the advantages of tax deferral by comparing rates of any kind.
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http://www.bogleheads.org/forum/viewtopic.php?t=14166
I've got a dead horse in back if you guys want to beat it with a stick.
Redbeard has it right on that thread - read him if you want the lowdown. Using average tax rates in retirement is wrong.
I've got a dead horse in back if you guys want to beat it with a stick.
Redbeard has it right on that thread - read him if you want the lowdown. Using average tax rates in retirement is wrong.
Assets - Liabilities = Equity + (Income - Expenses)
Re: Why the Roth IRA Bias?
The tax situation is usually close to a wash. The most common reason for preferring a Roth to a 401(k)/403(b) is that the investment options in the Roth are usually better. Most 401(k) plans have no fund with an expense ratio as low as 0.5%, or possibly have just one, an S&P 500 index which is not suitable for your whole portfolio. Even a good 401(k) is not likely to be as good as a Roth in every asset class; a diversified international fund with an expense ratio of .20% (Admiral shares of Total International, which you can now get in two years) is very rare.Kevin M wrote:I'm puzzled by the apparent bias toward using Roth IRAs, given that the choice between traditional and Roth should be determined by each individual's tax situation. The bias is apparent, for example, in the wiki, which recommends contributing first to 401(k)/403(b) to maximize employer match, then to a Roth IRA, then back to 401/403. I would think the recommended second priority should be traditional or Roth IRA depending on whether or not you expect to be in a lower tax bracket when you retire.
If you have better investment options in your 401(k) than you can get on your own (such as the government's TSP, or an employer plan with institutional shares of Vanguard funds), then it may be worth maxing out your 401(k) first.