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Author: LaughingRaven Big red star, 1000 posts Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 75882  
Subject: Re: What are your thoughts? Date: 8/14/2007 2:11 PM
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I have read that, sometimes, you might be better off to NOT put your money into a tax-deferred investment (such as IRA or 401K). The fees are certainly one issue. I think the main argument here is this: Yeah sure you get the money in pre-tax, but when you take it out you are taxed at standard income tax rates (+ a penalty if you took the money too soon). I think this may have applied to the "Traditional IRA" but is still something to consider.

That's one of the criticisms that people have against tax-deferred investment vehicles like Traditional IRA's and Traditional 401(k)'s. Normally, dividends and long-term capital gains are taxed at a lower rate than regular income. Traditional retirement vehicles don't make that distinction, so everything's taxed as ordinary income. So you could wind up with a bigger tax bill than you would have had in a taxable account. Oh yeah, and the tax hit comes after you've retired.

Suppose you open a Traditional IRA, you invest $4,000 in a basket of companies you believe in, and you forget about the account. You don't add more or sell anything. Thirty years later, you get a letter in the mail saying that it's time to take withdrawals, and your holdings have grown to $70,000. [For simplicity, let's suppose this is all capital appreciation, and none of your companies paid dividends.] In a taxable account, you'd have paid 10% tax (10% x (70K - 4K) = $6,600) on your long-term capital gains. However, Traditional IRA distributions get taxed at your marginal tax rate. If you're in the 25% bracket, that's (25% x 70,000 = $17,500). Even factoring out the deduction you got up front, you're paying almost $10,000 more in taxes.

Roth IRA's and Roth 401(k)'s sidestep this problem by not taxing eligible distributions; the more important distinction here is that if you're going to max out your Roth vehicles, and invest further in taxable accounts, the less tax-efficient investments (like REIT's, high-churn mutual funds, taxable bonds, and income-producing stocks) should be in the tax-advantaged accounts, and the more tax-efficient investments (index funds, municipal bonds, and stocks you plan to hold for many years) can be in the taxable accounts. Overall, this should maximize your tax breaks. IWANTSOMEGREEN, as young as you are, I see no reason why you shouldn't max out your Roth IRA contributions before considering other investments.

--
Raven
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