IRA's Vs. Mutual Funds

kaitainen wrote:

your marginal tax rate is 30% (combining federal, state and social security/medicare)

Small point, but I believe SS and medicare are taken out of all your income. There is no deduction for IRA contributions.

Therefore, you can leave less in a non-IRA rainy day fund. You still want one though - you don't want to be raiding your Roth IRA on a regular basis.

If you have enough contribution money in your Roth to fulfil your rainy day needs, then you should max out all your other IRA oportunities (traditional, 401k, educational, HSA) before saving anything outside those vehicles. But keep in mind, those Roth contributions are only available without penalty after the account is 5 years old. So before then you definitely need something on the outside.

One thing that complicates the whole picture is the fact that the current capital gains tax is 15%(in most cases). Distributions from traditional IRA's will be taxed as income (even though they will be largely capital gains). So it's possible you might be better off forgetting about the deferred taxation IRA advantage, and just pay 15% on the gains from your non-IRA accounts. Of course, who knows if capital gains taxes will still be 15% 40 years from now. But like I say, it complicates the picture.

kaitainen wrote:

with a roth IRA, you pay tax on the money before contributing.

I have a roth IRA and have never paid any tax on it that I know of. I do my taxes through H&R Block and they know I have a roth. Is something wrong here?

kaitainen wrote:

For a traditional IRA:

- you take a deduction now for the amount that you contribute to the IRA. If you contribute $1,000 and your marginal tax rate is 30% (combining federal, state and social security/medicare), you are essentially able to invest $300 more than you would have been able to without using an IRA.

Not a good way to explain it. A better way would to say that your $1000 in a traditional IRA costs you less than the same $1000 you put in a Roth. The investment is still the same.

Everyone's making this simple investment medium so complicated when it's not.

Regular IRA

- tax benefits NOW

- investment accrues tax free.

- penalties and taxes for early withdrawals (with some exceptions)

- must start some distributions at age 59

- must take substantial distributions at age 70

- can increase your taxes on social security benefits

- if you die early you've already received the tax benefits

Roth IRA

- tax benefit later

- investments accrue tax free

- funds are always available, tax-free and without penalties (subject to minor rules)

- no forced distributions

- has no effect on the taxation of SS benefits

- if you die early you won't see the tax benefits

Summary: Traditional: benefit now, funds not available now, no heartbeat risk. Roth: benefit later, funds available now, heartbeat risk.

hold up.... wrote:

I have a roth IRA and have never paid any tax on it that I know of. I do my taxes through H&R Block and they know I have a roth. Is something wrong here?

what this means is you use "post-tax money" to contribute to a Roth. there is no special Roth tax. so you probably don't notice that you are using post-tax money - you're just used to it. you use post-tax money for just about everything else too.

I think he meant you can't deduct it from your taxes - by not deducting it you are paying taxes on that money - although you won't be taxed on appreciation or withdrawals from the Roth. Subject to the income limits, you usually can deduct contributions to the traditional

My company began offering ROth 401k this year - does anyone do this? I may start next year, but this year stuck with the regular 401k to avoid the bigger tax hit now.

Forgot one thing.

Traditional IRA: Available to everyone

Roth IRA: Not available to everyone.

Roth has an income limit

hold up.... wrote:

I have a roth IRA and have never paid any tax on it that I know of. I do my taxes through H&R Block and they know I have a roth. Is something wrong here?

Yes, you're understanding of what is going on.

You received income from your job, it was taxed, you put some money into your Roth IRA, it grows tax-free.

With a regular IRA you are not taxed on the money you put into your IRA.

dukerdog wrote:

Small point, but I believe SS and medicare are taken out of all your income. There is no deduction for IRA contributions.

One thing that complicates the whole picture is the fact that the current capital gains tax is 15%(in most cases). Distributions from traditional IRA's will be taxed as income (even though they will be largely capital gains). So it's possible you might be better off forgetting about the deferred taxation IRA advantage, and just pay 15% on the gains from your non-IRA accounts. Of course, who knows if capital gains taxes will still be 15% 40 years from now. But like I say, it complicates the picture.

Thanks for the first point - I honestly wasn't sure about SS tax and I should have mentioned that.

Your second point that I've quoted is interesting, but I'm pretty sure that it is incorrect mathematically.

Let me try a simple math example of traditional IRA vs. regular, non-retirement account, investment.

Traditional IRA:

$1,000 contributed ($300 tax savings). 900% return during your working years (a factor of nine if I'm conceiving of this properly). Leaves you with $10,000 (original $1,000 plus $9,000 of gain).

30% tax on distribution, leaves you with $7,000.

Non-retirement investment:

$700 invested ($1,000 - $300 tax). 900% return during working years (we'll ignore dividends in this example, which in the real world would be taxed in a non-retirement setting and would dampen your rate of return). Leaves you with $7,000 (original $700 plus $6300 of gain).

15% tax on sale (on just the $6300) = $945, leaving you with $6,055 ($7,000 - $945).

You'll note that if the second example was a Roth, you'd end up with $7,000 (no $945 capital gains tax). This is not an accident or a coincidence. As long as the tax rate now and the tax rate at retirement is the same, a Roth and a traditional will leave you in the same place post-taxes.

Incidentally, the Roth calculation is also what you would get from a non-retirement investment that benefits from a "stepped up basis at death" (except that you wouldn't be able to receive dividends tax-free during your lifetime). So if you invest outside of a retirement account and you die with gain assets, your heirs will never pay tax on that gain (assuming estate tax law doesn't change over time - and that assumption is pretty much ridiculous).

Money magazine on-line has an article which says the priority should go:

'

1. To a 401k only to the point where it is matched by the company...then after

2. Roth IRA.

kaitainen,

You're nitpicking with some details here. Yes there are some ways to take your money out of a Roth IRA with no penalty, but if you read that example that you provided, there are many ways that you WOULD have to pay a 10% penalty for early withdrawal. Here's a direct quote from the thing YOU prpvided - "The return of the $10,000 taxable preconversion assets would be tax free, but would be subject to the 10% early distribution penalty (unless an exception applies)."

Good grief. Plan on having your Roth IRA or traditional IRA be for RETIREMENT and don't play to take from it early. I'm giving this guy GENERAL advice here, not getting into nitpicking details -- he's a complete beginner and didn't need your minutia there (which happened to be wrong anyway). You are saying that there is NO penalty for a Roth IRA for early withdrawals, and MOST of the time, that is NOT true.

Also, who the hell creates an IRA that isn't made up of investment vehicles? Sure in hell not me. Again, mine has made about 12% each year since I've had it. You're coming up with situations that NO PERSON IN THEIR RIGHT MIND would create.

Also, if you buy just a MUTUAL FUND that is not in a 401k or an IRA, it IS more liquid than either an IRA or a 401k -- like I said. I can go take money out of my American Funds mutual fund if I want to and just pay taxes on it. There is not penalty other than that associated with it.

Not sure what your deal is kaitainen, but I'm clearly not wrong with the above things.

I was wrong on the IRA limit though. Looks like for 2007 it is $4,000 not $4,500. The 401k limit though is $15,500 like I said.

Only an idiot would set up an IRA for the purposes of taking money out of it regularly before they retire. It is a RETIREMENT ACCOUNT. You should ONLY take money out of it in an emergency, or when you retire. Set up other accounts for rainy day funds.

Sorry if I am repeating what others wrote since I only read the first post.

Roth IRA = an account where you contribute money and invest and grow tax free. You can contribute $4000 (more if you are old) into your ROTH IRA for 2006 until April 15(if you haven't done your taxes and another $4000 for 2007. ($8000 for each year if you are married and make less than a certian amount that I don't feel like looking up but around $150,000)

Mutual Fund = an investment company that continuually offers new shares and stands to redeem existing shares from owners. Generally, an investment company buys a bunch of different stocks with a plan/strategy or within a sector of the market. You can buy shares of that fund. (I'd only go with no load funds myself). I actually prefer most of my core holdings to be a no load, low annual cost, total market index instead of a managed mutual fund that have higher expenses each year and often underperform the market.

But if you are limited in the amount of money you can set aside for retirement, I'd make sure I'd get the match if your company offers a 401(k) with a matching provision. After you contributed enough inside your 401(k) plan to get the maximum in matching contributions, I'd max out the Roth.

No wonder I am doing so well financially, you are all a bunch of idiots.

here is the complete quote that you misleadlingly truncated:

"EXAMPLE 1: On January 12, 1998, Georgia, age 52, opened a Roth IRA at Ace Financial Organization with a $2,000 contribution. Later in the year on April 10, 1998, Georgia completed a conversion of $10,000 from her Traditional IRA to a Roth IRA and elected to and paid all of the taxes on the conversion for 1998. All of Georgia’s Traditional IRA dollars that were converted were pre-tax dollars.

Georgia was let go from her job in May 1999. In July 1999, Georgia withdrew $1,000 from her Roth IRA to pay the mortgage. Georgia may think that this distribution would be subject to the 10% early distribution penalty. Georgia, however, will not have a 10% early distribution penalty because the ordering rules state that the first assets out will be a return of contributory assets if the Roth IRA holder has contributory assets in any of his or her Roth IRAs. Therefore, Georgia’s $1,000 distribution is considered to be made from the $2,000 contributory Roth IRA assets. Because the $2,000 represents contributory (not conversion) assets, the $1,000 is tax and penalty free. Remember that the 10% penalty does not apply to nonqualified distributions attributable to contributory assets.

EXAMPLE 2: In the previous example, if Georgia needed to take a $12,000 distribution in May 1999, $2,000 would be tax and penalty free as a return of contributory assets. The remaining $10,000 attributable to taxable preconversion assets would be tax free, but would be subject to a 10% penalty unless Georgia met one of the exceptions under IRC Sec. 72.

EXAMPLE 3: Assume from example 1 that Georgia needed to take a distribution of all of her Roth IRA assets: $13,000 (i.e., $2,000 contributory assets, $10,000 taxable preconversion assets and $1,000 earnings). The $2,000 return of contributory assets would be tax and penalty free. The return of the $10,000 taxable preconversion assets would be tax free, but would be subject to the 10% early distribution penalty (unless an exception applies). The distribution of the $1,000 in earnings would be taxable and subject to the 10% penalty (unless an exception applies). The earnings are taxable since the distribution was nonqualified as defined previously."

This example CLEARLY states that withdrawing contribution assets is not penalized. That is what I said and for some reason you are not willing to believe it.

You can contribute to your Roth to your heart's content knowing that in an emergency the contributions can be reclaimed penalty free.

You pay a penalty on withdrawing the gain. That's not what I was talking about. And it is not minutiae in the short term. The large majority of your Roth account will be contributory assets for the first 5+ years (assuming annual contributions of similar sizes of course).

And as for your self-righteous crap about whether putting money into an IRA causes it to gain interest - I was answering the OP's question. He asked a valid question for someone new to this and I explained it to him accurately. You will notice that he then started another thread asking about what assets he should put in his IRA. He needed the information that I provided and it was accurate.

Finally, the Roth IRA would not be set up with the intention of taking money out of it before retirement, and you will notice that I advocated an emergency fund on top of the Roth, but a Roth (as opposed to a traditional) will indeed be an effective emergency fund to the extent of contributions. For someone who is young and who reasonably expects income increases in the near future, it probably makes long-run financial sense to put as much into a Roth as possible and forgo the emergency fund, depending on that person's details. I'm risk averse so I still wouldn't do it, but that doesn't mean my actions would be rational.

Kaitanen, you know your stuff, however I think your example is misleading for a rel world setting. I contributed to an IRA when I was first working and in a very low income tax bracket--this was before Roth's were available. When the Roth first came on line I converted everything and claimed the income. However, I was married, owned a house, had two kids, and still earned a very modest income. I never owed any taxes on any of that conversion or on any new contributions. In such a case I would have been an idiot to consider anything but a Roth.

The answer on Roth vs. traditional comes down to "it depends" just about always. And it also involves factors (future tax rates-and structure, who knows we might have a consumption tax one of these years) that cannot be predicted in advance.

How do I physically start an IRA with say, Vanguard for example?

Mr. Obvious wrote:

The answer on Roth vs. traditional comes down to "it depends" just about always. And it also involves factors (future tax rates-and structure, who knows we might have a consumption tax one of these years) that cannot be predicted in advance.

good post, Mr. Obvious. i try to avoid pushing roth or traditional too hard in any post because individual factors do really determine the decision. anyone considering the choice for himself should definitely make use of readily available, high-quality online calculators.

the one point that i hope i've been able to get across is that there is no inherent difference mathematically between the two choices. with the same tax rates and the same amount of money available for investment, you end up with the same result at retirement.

but as you point out, those assumptions are unrealistic in real life. you need to take your real life situation into account.

there are more details to consider if one wants to spend the time - are you maxing out your contributions, do you have income above the social security tax ceiling (relevant only in the 401(k) context really), have you properly taken "tax diversification" into account, etc.

but for a beginner with relatively limited income, going with the Roth is pretty much a no-brainer. your example was helpful in that respect.-

Here's Vanguard's retirement account section:

https://flagship.vanguard.com/VGApp/hnw/planningeducation/retirement?Entry=Homeoffer02

(you probably shouldn't trust me though to be honest (identity theft and all that) - type

http://www.vanguard.com

into your browser and it's clear where to go from there - click on "go to the site" and then "IRAs, 401(k) rollovers, retirement investing").

on that page, click "Open a Vanguard IRA."

it's very easy.

and i'm sure a similar process exists at fidelity, t. rowe price, etc.

Call the 800 number for Vanguard and tell them you want to start an IRA. They will send you a kit with papers to fill out. Usually there is a low minimum investment. It is usually lower when you agree to an automatic monthly contribution via bank draft.