Roth/Trad IRA - Help?

[Anonymous]

Hi community,

I've been researching IRAs and trying to decide which would be the best route (roth or traditional) given my circumstances.  I may ask Vanguard, Charles Schwab, or whomever for more insight towards the end of the year; but I would like hear your thoughts on the matter.  Quick background:  mid-20s, 42k salary (well below the roth MAGI limit), very minimal expenses aside from my student loans which I should have paid off in full by the end of next year.  My firm also offers a SIMPLE IRA which I will be funding fully at the end of the year. My goal is to retire early and live off of the money I have invested over the years.

This may get a bit technical. 

Now, I know the basics of each.  Traditional is pre-tax, can't be funded after 70, RMD, etc.  Roth is after tax, limited to MAGI, no RMD, contributions can be withdrawn early under certain circumstances, etc.  

A lot of people would immediately answer Roth IRA; but why?  One of the presumptions I've seen is:  "you won't be taxed (on contributions and gains) in the future, which is great, because taxes will be higher in the future."  When people say that taxes will be higher in the future, is that an assumption that the government will increase the ordinary gains tax?  I've also seen some arguments saying that one will be in a higher tax bracket;  I guess that's another assumption where, in retirement, I will have somehow accumulated enough such that my interest, dividends, or whatever distributions during the year will be greater than my current  and future salary?

I'm currently under the assumption that retirees make much less than when they were working (social security taken into consideration);  so why would I be in a higher tax bracket when I retire?  I would conclude, then, that if I fund a Traditional IRA, I would be paying less tax in the future. 

Another question is:  if I do decide to fund a Roth IRA, but my MAGI eventually increases to the point where I am no longer able to contribute to it... what happens then?  Will I have a Roth IRA, funded for x number of years, growing in isolation?  And if I still wanted to contribute to an IRA, it would have to be a Traditional which will create a separate account with a different time table (start date)?  Defeats the purpose of compounding interest, no?  So should I fund half Roth and half Traditional this year and go from there?  

Does my reasoning make sense?  Any clarification or suggestions would be greatly appreciated!  Thanks.

[bada_bing]

Calculating future tax rates requires some assumptions which may or may not come true.

Tthe expectation that tax rates will increase in the future is widespread, but not proven. One

interesting wrinkle that I see get very little discussion is the possibility of a national sales tax

replacing some/all of the income tax. That would really throw a monkey wrench in all the

retirement planning using Roth accounts.

Generally the longer timeframe until withdrawal, the better a Roth looks. That's because

the longer gains can compound, the greater percentage of the total account value is composed

of interest/cap gains verses original deposits. Roth acounts have a powerful advantage 

for money invested early in a working career, but the advantage dwindles for money invested

closer to retirement/withdrawal.

I like Roths because of the lack of RMD and the ability to access original contributions without penalty

in case of emergency. Also, the yearly caps on Roth contibutions are effectively larger, because it

is after tax money. If maximizing the amount contibuted yearly is a priority, the Roth allows for

effectively more income to be put to work. I max out my 401K yearly with Roth contributions in part

because I'm trying to catch up for a hopefully early retirement in just a few years. My contribution

limit as a Roth is effectively larger by the percentage of the tax bracket I'm in. .I'm lucky to have a

Roth 401K option from my employer, my AGI is high enough that the only IRA I'm eligible to

contribute to is an After tax traditional. I have some Roth IRA money I contributed before my income

increased enough to stop it. All that happens is the loss of ability to make new contributions.

One other thing to consider is the ability to use a Roth conversion on Traditional IRA balances. It

only goes one way. You can convert to a Roth, but not from a Roth back into a tradional, at least

not in any beneficial way. If you start with a traditional IRA, that money isn't necessarily locked out

of your Roth in the future. Once I retire, I will have a lower taxable income and will check the numbers

for doing a roth conversion on existing Traditional balances on a regular basis.

Lots of stuff to consider and uncertainities to consider.

[tacpoly]

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@Anonymous wrote:
When people say that taxes will be higher in the future, is that an assumption that the government will increase the ordinary gains tax?

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First let me correct you on one thing:  you will get taxed ordinary income tax when you finally take retirement distribution from a Trad (pre-tax) IRA, not capital gains. 

One reason to contribute to a Roth now is because your tax rate is relatively low so your savings from tax-deferred investments (i.e. Trad IRA) is pretty low.  I am one of those who think that the tax rate will eventually go up -- because we're eventually going to have to pay for infrastructure and entitlements have we have been putting off forever.  I think that by the time you retire, the tax rate on $42,000/year will be higher than the tax rate now.  (To me $42,000 is a decent yearly retirement income)

Besides a Roth does not lock down your principal contributions the way a Trad IRA does.  It offers some flexibility should you need funds in an emergency (although I would strongly discourage ever dipping into retirement savings). 

If your income increases above the Roth maximum income limit, you can always do a backdoor conversion where you fund an IRA post tax (which doesn't have an income limit) then convert that to a Roth.

Also, contributing early then letting it grow untouched without continuing to contribute to it isn't such a bad thing (as long as you periodically balance).  I think some people are more tempted to raid their retirement savings when they see money pile up so it might be better to "forget" some accounts. 

Whatever you decide, you should start now to take advantage of your long time-frame. 

[Anonymous]

I see your reasoning. The taxes you pay now with a Roth is so much lower than it would be say 30 years from now are so benificial, that's why they cap it at 5.5k. Personally I have an illness that runs in my family, I have 50 percent chance of having it. I'll be getting tested in the next 5-10 years. If I have it, I'll be retiring early become and traveling for a few good years. If I dont, I don't. But a Roth lets withdraw whenever on the principal. I need a third or fourth tier of emergency accessible cash.

[youdontkillmoney]

In my case the government made the decision for me, if you make a certain income above a limit you cannot go the Roth route, in my case married filing jointly we earn above $193K together, so we both have traditional IRAs:

http://www.rothira.com/roth-ira-limits

[Anonymous]

i wonder if the gov would extend the limits for the millennialist since they are/will be so debt burdened without the guarantee to gov assistance when they retire. 

[tacpoly]

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@youdontkillmoney wrote:

In my case the government made the decision for me, if you make a certain income above a limit you cannot go the Roth route, in my case married filing jointly we earn above $193K together, so we both have traditional IRAs:

http://www.rothira.com/roth-ira-limits

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You can still backdoor your traditional post-tax IRA contributions into a pre-existing Roth account.  Just make sure you don't have a lot of pre-tax IRA contributions because you'll have to pay income tax on that percentage of your conversion. 

[tacpoly]

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@Anonymous wrote:

i wonder if the gov would extend the limits for the millennialist since they are/will be so debt burdened without the guarantee to gov assistance when they retire. 

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doubt it.  the gov't is giving up a lot of future revenues with the Roth already. 

you can take advantage of catch-up contributions when you're older. 

[nightglider]

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@Anonymous wrote:

I see your reasoning. The taxes you pay now with a Roth is so much lower than it would be say 30 years from now are so benificial, that's why they cap it at 5.5k. Personally I have an illness that runs in my family, I have 50 percent chance of having it. I'll be getting tested in the next 5-10 years. If I have it, I'll be retiring early become and traveling for a few good years. If I dont, I don't. But a Roth lets withdraw whenever on the principal. I need a third or fourth tier of emergency accessible cash.

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Slight correction: The $5.5k limit is not a Roth/Traditional limit, but an IRA limit. Those whose employers offer Roth 401(k)'s can make the same after-tax contributions with the same 401(k) limit.

The reasoning I thnk you're referring to has nothing to do with assuming a raise in income taxes. Traditional contributions are effectively less because assuming everything is equal (amount/rate of contributions, rate of returns, etc), Roth and Traditional accounts (both IRA and 401(k)) will have the same balance when you're ready to retire, but your Traditional will be taxed and your Roth will not.

[Anonymous]

My Roth IRA is capped at 5.5k.