I figured that subject would peak someone's interest. I am , in fact, looking for a financial model or calculation to help with an impending investment decision.I am trying to determine if a non-deductible IRA will be better than a standard brokerage account as a savings vehicle for retirement.The following facts and assumptions are at work here:* I contribute the max to my 401k (an index fund)* My wife does not have an employee sponsored plan* Our AGI exceeds the limits for any deductible contributions* We will apply the same investment approach to either the std. brokerage account or a self-directing IRA(possibly Foolish four or a buy and hold strategy)* Our needs in retirement will be 100K annuallyI guess the real question(s) boils down to: Will the tax deferred growth of the non-deductible IRA outweigh the benefits of only paying capital gains on the std. brokerage account?I have been unable to locate or derive a good model to take into account he tax deffered growth and the long and/or short term capital gains implications.Sorry for the lengthy messasge...any help/advice would be greatly appreciated. Thanks in advance.
Danielrh: I am trying to determine if a non-deductible IRA will be better than a standard brokerage account as a savings vehicle for retirement.The following facts and assumptions are at work here: * I contribute the max to my 401k (an index fund) * My wife does not have an employee sponsored plan * Our AGI exceeds the limits for any deductible contributions * We will apply the same investment approach to either the std. brokerage account or a self-directing IRA(possibly Foolish four or a buy and hold strategy) * Our needs in retirement will be 100K annuallyI noticed you didn't mention the Roth IRA as an option. Is this because you & your wife exceed the limits for a Roth contribution? I'm assuming that you make >$160K AGI, since that's the upper limit for a non-participating/non-working spouse to make a deductible IRA contribution. If you are eligible for a Roth, then it's your best choice.For a good rundown of the factors to consider between a Roth & your other options:http://www.fairmark.com/rothira/thumb.htm I guess the real question(s) boils down to: Will the tax deferred growth of the non-deductible IRA outweigh the benefits of only paying capital gains on the std. brokerage account?A lot depends on your investing style in the taxable account. If you hold less than a year & incur short term capital gains taxes, you'll certainly lose out to the IRA's tax-deferred growth. Another mistake would be to buy stocks which pay high dividend yields, since they also are taxed as ordinary income. Theoretically, it's true that a LTB&H investor in a taxable account could end up with more after-tax money due to 20% LTCG, but in your case why not have both? If you're making >$160K, then funding 2 $2K IRA contributions & contributing additional money to a taxable account shouldn't be too hard. Consider it a form of diversification or hedging, since you don't know what either income tax rates or LT cap gains rates will be in 20-30 years.If you're looking for someplace to get additional money, you might consider not funding your 401K beyond the employer match & investing the balance Foolishly yourself. Over the long term, you should be able to beat the S&P, even in a taxable account. Try this link for details: http://www.fool.com/DDow/1998/DDow980819.htmChris
Chris-"A lot depends on your investing style in the taxable account. If you hold less than a year & incur short term capital gains taxes, you'll certainly lose out to the IRA's tax-deferred growth. Another mistake would be to buy stocks which pay high dividend yields, since they also are taxed as ordinary income."Thanks for the advice. Good point about the high dividend yielding stocks.With regards to the non-deductible IRA, are there any capital gains implications from following a Foolish 4 approach?
danielrh wrote,<<I am trying to determine if a non-deductible IRA will be better than a standard brokerage account as a savings vehicle for retirement.>>Assuming you invest primarily in stocks rather than bonds and follow a "long-term buy and hold" strategy, I think the standard brokerage account would be better than a non-deductible IRA. This is true largely because capital gains are taxed at a max of 20% while a $100,000 annual income derived from IRA withdrawals would put you in the 31% bracket. You would have to do quite a bit of trading in the brokerage account to absorb the 11% difference in tax rates. You might also want to look at something like Vanguard's Tax-Managed Growth and Income Fund. This fund is designed to limit (or eliminate) the annual capital gains distributions that are so troublesome to investors holding mutual funds in a taxable account. It is basically an s&p500 index fund with an expense ratio of 0.19%.intercst
danielrh Date: 3/14/99 12:42 PM Number: 9119 I am trying to determine if a non-deductible IRA will be better than a standard brokerage account as a savings vehicle for retirement.You are going to have make some assumptions to answer this. Here's the answer for one set of assumptions:Assume capital gains tax will always be 20% for you.Assume regular income tax rate will always be 30%Assume you have 15 years of investment horizon.Assume you can earn 20% on your investments, all capital gains.Assume you will realize all of your gains every year.Then for every dollar invested in an IRA today you will have (1.20)^15 = 15.407 dollars in 15 years. You will pay 30% of the growth = 0.30*14.407=$4.322, leaving you with $10.085 after taxes from the IRA.In the taxable account, each year a dollar will result in 0.20 profit, and you will pay 20% of that, or 0.04, in tax every year. So the taxable account will grow at 16% per year after taxes. In 15 years, each $1 now will become 1.16^15=$8.266.So for this set of assumptions, the IRA is a much better investment. Invent a dozen or so scenarios that seem possible for you, and repeat the calculation.
danielrh wrote in part:I am trying to determine if a non-deductible IRA will be better than a standard brokerage account as a savings vehicle for retirement. ...You say you can't make deductible contributions, but you don't say if you fall below the $150K AGI to allow investing in a Roth IRA. If you qualify, the Roth is definitely the better option. Your contributions are taxable, but withdrawals after 59.5 are tax tree, and since this is an IRA, there is no capital gains taxes on trades in the account.If you can't qualify for a Roth, then you'll have to run the numbers comparing a traditional IRA with a taxable brokerage account. A spreadsheet is the perfect tool for this. If you're going to practice a LTB&H strategy, then I'd expect the taxable brokerage account to come out way ahead (depending on time) because your tax rate at retirement should be quite a bit higher than the long term capital gains tax rate, and since you're not accumulating captial gains taxes along the way, that helps. The situation is a lot greyer when you start talking about a FF strategy. Since you're buying and selling stock each year, if you're not in an IRA, you have to worry about capital gains taxes (try to make them long term if you take this route). The longer you have til retirement, the more attractive the IRA option looks in this scenario. But where the crossover point is, I don't know, or even if the taxable account approach is ever better.Another thing to consider is you're limited in how much money you can invest in an IRA per year, but not so with a taxable account. You can have two IRA's (one for you, one for your wife), so that's $4k per year.Bottom line is, if you can do a Roth, do that then a taxable account. If you can't do a Roth, then you need to sit down with a spreadsheet and get your hands dirty with some numbers. Think it through carefully, whatever you do.--DarkOut
Snootfool:Another mistake would be to buy stocks which pay high dividend yields, since they also are taxed as ordinary income.danielrh:Thanks for the advice. Good point about the high dividend yielding stocks. With regards to the non-deductible IRA, are there any capital gains implications from following a Foolish 4 approach?Not really, since a Trad. IRA converts all gain to ordinary income. OTOH, when investing in a taxable account with any of the Dow Dividend Approaches (FF, RP, etc.) you obviously must factor dividends into the tax picture. Currently, dividends are at historically low yields, so right now it's no big deal. However, over the last ~70 years, dividends have represented a much bigger piece of the overall growth & income equation (about 30-40%, IIRC). When (or whether) yields will rise again is anybody's guess. My 2 cents: even if a Traditional IRA loses out in a specific scenario to a taxable LTB&H system, an IRA gives you additional flexibility to trade in the short or medium term without worrying about tax or tax paperwork. If you're at all inclined to trade on less than a yearly basis (in my own case, all of my Internet stocks are held in an IRA, so that I can bail out if things go south without taxes being a factor), then you definitely would benefit from an IRA to supplement your taxable account. Chris
<< * Our needs in retirement will be 100K annually >>Gee, that sounds like a lot of money.Are those actual needs? Or just something that sounds good? If 100K is that all you figure your portfolio will produce, maybe you should plan to take down a bit less and invest the difference, so that the available income will increase over a period of time, because...As we age, our actual needs often increase and only rarely decrease. Moreover, the actual costs of our actual needs usually increase over time.Sincerely,DHatch
This is all very interesting. I am also deciding whether to get a non-deductible IRA. I do not qualify for a deductible or a Roth IRA.Is not the original $2000 in a non-deductible IRA will also be taxed as regular income when we withdraw it at retirement?
Greetings, YoungChibo, and welcome. You asked:<<Is not the original $2000 in a non-deductible IRA will also be taxed as regular income when we withdraw it at retirement?>>No, the contributions to a nondeductible traditional IRA do not get taxed on withdrawal. They were taxed before they were contributed. The earnings on those contributions do get taxed at ordinary rates, though. At withdrawal time, anything you take will consist of a partial return of your original contributions and a partial distribution of earnings. So part of every withdrawal gets taxed at ordinary rates, and part doesn't. See IRS Publication 590, Individual Retirement Arrangements, for the computation details. You can get that at www.irs.gov.Regards....Pixy
I do not have a model. But I think you can easily build one if you have the following information. 1) Tax rate used during contribution years and the tax rate used during retirement years. 2) Average holding period for investments. 3)Portfolio Turnover 4) Portfolio mix (equity vs fixed income)Remember that you only pay taxes on the excess amount above your basis(contribution) in the IRA acccount. (Which is $2000 max per year per spouse) I have a non-deductible account for myself because I am in a high tax bracket, my investments throw off alot of dividends and interest. In additions the porfolio has high portfolio turnover rate, which would generate alot of short term gains if currently taxable. My hope is that the compounding of tax deferred IRA funds would provide a larger future value vs paying taxes yearly. I plan to manage my distributions during retirement to further minimize my subsequent tax liability. Alan Fields, CFA,CPAClayton Capital Management
***WARNING, L0NG POST***1) Can you contribute to a Roth IRA (I don't know if there is an upper limit for contributing to a Roth...)2) How long until retirement?3) What chance that you will need this money before retirement? I'll assume that you can sit on it until then.Answers (at least *my* answers, due your own checking)A) If you can use a Roth, do so. Money goes in and out "after taxes" and you will not pay taxes on it.B) If you can't use a Roth, plug the numbers into a spreadsheet, making assumptions where you need to.I'll assume a 28% marginal tax rate for you throughout and a 20 year time frame. Also will assume 11% gain/year. I ran the analysis assuming 20% cap gains tax rate (versus 28% income tax rate). And also assumed various turnover rates in the standard brokerage account (expressed as % portfolio turnover/year, also assuming that all portfolio turnover is just cap gains). I didn't factor in dividends.annual turnover % ira brokerage0 12170 1330010 12170 1255120 12170 1216950 12170 1172475 12170 11586100 12170 11511Note that the various assumptions I have to make may affect the outcome. In general, is looks like if your portfolio turnover per year is more than about 20% your are better off in a non-deductable, non-Roth IRA.I also ran 40 years, in that case, IRA wins out unless the portfolio turnover is less than about 3-4%/year.I guess I need to add another condition -- that being whether your are susceptible to trading a lot. If so, then go with the IRA.As above, Roth IRA wins out in all cases if you are eligible.
I see no advantage to a Roth IRA unless one is going to be aggressively trading with multiple short term gains or even multiple long term gains. If you are, instead, going to buy msft,intc,yhoo,aol,sch,egrp,pfe,mrk,c,hwp,csco and similar rule makers, rule breaker types and hold them for the long haul, like you know you should, you will have no long term advantage as to the amount of capital you will amass in the long term. A few switches and sales won't matter much.Then, when you retire and start liquidation, you will only have to pay long term capital gains taxes on the gain portion only. This is a wonderful retirement tax break.Plus, when you die your heirs will inherit your stocks at the price they are when you die (or 6 months later) and they will not owe the income taxes on 100% of a Roth IRA. IN SUM, there is way too much hype about Roth IRA's. Uncle Sam knows he will eventually get your money.No question but you want to have a large portion of your retirement money in non-retirement accounts where
Oloss wrote:<< ...Plus, when you die your heirs will inherit <<your stocks at the price they are<< when you die (or 6 months later) and they will not <<owe the income taxes on 100% of a Roth IRA. Forget that! Talk about bad advise! Enjoy your money! Take a few vacations in Tahiti. The "#*@!" heirs will just blow your money on cars, high definition TV, and club idiot vacations! Let the heirs pay the taxes! :) RBrowndog
<I guess the real question(s) boils down to: Will the tax deferred growth of the non-deductible IRA outweigh the benefits of only paying capital gains on the std. brokerage account?>Honestly, that is a question I have not figured out.But what about a ROTH IRA? Since you already would pay taxes on the money you might put into an IRA, a ROTH IRA would grow tax free, i.e. no taxes to be paid at withdrawal. And no minimum required distributions that might be tedious to do and throw a person perhaps into a higher than expected tax bracket. - After all, aren't we all planning to be very successful Foolish investors?
Oloss wrote: << ...Plus, when you die your heirs will inherit your stocks at the price they are when you die (or 6 months later) and they will not owe the income taxes on 100% of a Roth IRA.>>RBrowndog wrote:< Forget that! Talk about bad advise! Enjoy your money! Take a few vacations in Tahiti. The "#*@!" heirs will just blow your money on cars, high definition TV, and club idiot vacations! Let the heirs pay the taxes! :) >It's bad advice for more than the reason you propose. As stated a few posts above, one of the GREAT things about a Roth IRA when it comes to inheritance planning is that your heirs will NOT have to pay income taxes on it. Although this is true of a traditional IRA (since it is generally made up of mostly before tax money), a Roth IRA is after tax money, and thus no income taxes are owed. An easy way to view this is that when it comes to an inherited IRA, your heirs are only obligated to pay income taxes on what you would have been taxed on had you lived to draw down the entire IRA account. With the Roth IRA, since you owe no income taxes at withdrawal, neither do your heirs at your death. (Of course inheritance taxes on large estates are a separate issue).If this is typical of the reasons why the original poster feels that the Roth IRA is "way overblown", then perhaps he feels that way only because he doesn't really know as much about the Roth as he thinks.Wavelength
I guess the real question(s) boils down to: Will the tax deferred growth of the non-deductible IRA outweigh the benefits of only paying capital gains on the std. brokerage account?I constructed a rather simple model using an Excel spreadsheet to handle this particular problem, because I haved faced much the same kind of decisions regarding both my regular brokerage account and two IRA accounts (one rollover with some non-deductible contributions and another SEP/IRA account. The model I used made the following assumptions:Investment Return 25% per year.Tax Rate 36% LTCG Rate 20%Investment Horizon 20 years.Initial Investment $10,000. Because of the time horizon, the addition of $2,000 in non-deductible contributions tends to be diminished by the overall return of the portfolio.I then made one additional model which assumed that the balance would continue to be invested for 10 more years and withdrawn on a declining balance until exhausted at the end of 10 years, with appropriate tax rates. Based on this model, the tax-deferred portfolio fares much better than the standard portfolio in most instances. The exceptions occur when portfolio turnover is reduced to 10 years or more. In other words, if you can buy & hold the stocks in your portfolio for at least 10 years before incurring capital gains taxes, you will have an ending portfolio that will produce larger payments than the IRA portfolio when withdrawn over 10 years. In all other cases, the IRA portfolio produces larger payments.The typical example might be a FF portfolio which reinvests in a new set of stocks each year. In this instance, you can expect that the IRA portfolio will produce almost $230,000 more in payments over the 10 years than the regular portfolio. If held for a longer investment period, say 30 years, before drawing down the portfolio, the difference would be even more dramatic.As one of the posters earlier indicated, portfolio turnover will be the key to which kind of account to use. For those in which turnover will be made every year, the IRA will be king; for long-term (at least 10 years) buy & hold, the regular one will be better. In the case of the woman who started with $5K in 1944 and amassed a fortune of $44 million, no sales were ever made. This was the ultimate buy and hold strategy. An IRA would be left with about $28 million and a regular investor with $35.2 million. Turnover makes the difference.Regards,Stanley
StanleyManly, 25% return is correct for the last 5 years or so, but it is not historic. How would your worksheet look if you put in 10%? This is not criticism, I'd just be curious to know.
JABoa,Thanks for your observation. I tested and revised the model somewhat to include the 10% assumption. Made a couple of other tweaks also. The declining payments over 10 years were originally earning 5% and tax rates on both the standard and deferred payouts were 36%. I changed the entire model to use 10% earnings, including the 10 year payout period and revised the tax rate on the standard payout to 20%, for long term capital gains. As a result of this change, the ultimate payout for both scenarios is virtually the same after 10 years assuming that the portfolio is turned over every year. When using longer holding periods, some advantage goes to the standard portfolio. This seems to indicate to me a couple of things:1. The risk/reward of a higher assumed rate has more effect when used in a tax-deferred portfolio, especially when high turnover is present.2. If we assume a lower rate of return, it usually matters little which approach is taken, tax-deferred or standard while holding for one year.Just a note that the reason I used 25% as the assumed rate is based on the most recent stats from the FF using the RP4 variation which indicates a return of 24.6% over the past 25 years. For stock investments I tend to be much more aggressive (i.e., risky) than I might expect others to be. But you point out some interesting comparisons for me based on that approach.One other observation that I noted is that when payouts are made over a 10 year period, the effects of inflation, although minimal, could be taken into account. The deferred portfolio, pays more money out sooner than the standard portfolio, thereby making it worth a little more on a present value basis. This has been a good topic. I hope we get others like it in the future.Stanley
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