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Author: babyfrog Big red star, 1000 posts Old School Fool Home Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 75609  
Subject: Re: Contributing to a Traditional IRA Date: 3/15/2004 6:00 PM
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tmorella,

I'm of the opinion that "a bird in the hand is worth two in the bush." As such, if our household income ever rises above the point where we cannot contribute to Roth IRAs, we still expect to contribute to Traditional IRAs. Some primary advantages of Traditional IRA over taxable accounts follow:

1) The 'lockbox' penalty until age 59.5 or other 'qualifying' distributions.
Yes, I view the "substantial penalty for early withdrawl" as an advantage for me. It's an advantage for me because I don't trust myself to not spend my own money. Cash inside a retirement account is very expensive to get at (taxes + penalties + inability to replace), so I am much less tempted to spend the money in my retirement accounts than I am in my regular brokerage accounts, where the taxes are lower and I can always "make up the difference next month." A bird in the hand is worth two in the bush, and I'd rather pay 30% of SOMETHING to the tax man when I go to take out my retirement money at retirement than be treated to the ability to POSSIBLY pay 15% of NOTHING because I gave in to temptation and spent the money before I retired.

2) Tax deferral of capital gains and dividends.
I like dividend-growth style investments. By dividend-growth, I mean companies that pay and grow their dividends year after year... The problem with a taxable account, of course, happens when the dividends continue to grow, due to corporate increases, compounding of reinvested money, and additional contributions. What may start out as an easy "Oh, I'll pay the taxes out of pocket" may morph over the course of a long term career into a "holy cow, I owe HOW MUCH?" In an IRA, the annual carrying cost sticker shock gets reduced dramatically, especially in the later accumulation/working years.

3) AGI deferral of capital gains and dividends.
People whose AGI would preclude them from participating in a Roth IRA are also those who are hitting the range where the Alternative Minimum Tax may start to bite, especially if they're married homeowners with a second mortgage and children, living in high tax states. The less income that counts as AGI, the lower the likelihood and amount that can get hit with AMT rate taxation. This page: http://www.fairmark.com/amt/ltcg.htm has a good reference on what happens with AMT and capital gains and how the rates play out in practice.

4) The potential roll over into a Roth IRA.
I am aware of two ways to get money into a Roth IRA. 1) Contribute money into a Roth IRA. 2) Roll over a Traditional IRA. There is no path that I'm aware of to get money from a traditional brokerage account into a Roth IRA. If a currently Roth inelegible person or married couple anticipates a MAGI within the roll over range at some point, then contributing to a Traditional IRA can give that person or married couple the opportunity to roll that account into a Roth. For example, in states like Ohio where the marriage penalty is still alive, well, and gigantic, a strategy could be to file as married filing separately and contribute to Non-deductable Traditional IRAs. Then, when kids come along, when one parent is off on maternity or paternity leave and the marriage penalty is less of an issue or completely eliminated, the couple could file as married filing jointly and, if MAGI allows, roll the accounts into Roth IRAs. Because the original contributions were already taxed, the rollover tax would only apply to the gains.

5) Better protection against creditors.
Many states have laws shielding at least a portion of people's IRAs and other retirement accounts from creditors (though not, of course, from QDROs in divorce cases). I am not aware of any protections afforded to standard brokerage accounts.

6) Easier reporting/recordkeeping.
For people who invest in REITs or other securities that pay out different classes of income, some of which may adjust the investors' basis, the recordkeeping can get quite cumbersome. The same holds true for people who invest in securities that issue stock in lieu of paying cash dividends. In the case of an IRA, the only basis number that counts is the non-deductable contribution amount.

7) Fewer minefields to navigate for tax benefits.
Other than owning UBTI generating investments or engaging in prohibited transactions (see http://www.entrustadmin.com/Prohibited_Transactions/prohibited_transactions.html ) such as 'self-dealing', there are very few things that can cause an investor to lose the tax deferral of an IRA where the investor properly contributed the money. Contrast that with the laundry list of requirements for qualifying for the current lower capital gains and dividend tax rates. The Fool has a pretty good laundry list of the dividend minefields, here: http://www.fool.com/taxes/2003/taxes031003.htm . Oh, and for margin investors, the fun continues, as described here: http://www.fool.com/taxes/2003/taxes031205.htm . Since one of the arguements in favor of brokerage accounts over traditional IRAs is the arguement that the new lower tax rates may make it cheaper over the long run to invest in a brokerage account over a traditional IRA, an investor pursuing the brokerage account instead of IRA strategy must be sure to avoid those minefields.

8) Need for Congressional and Presidential action.
The current low tax rates on qualified dividends and long term capital gains is set to expire. Without Congressional and Presidential action, dividends will once again be taxed as ordinary income, and long term capital gains tax rates will go up. An investor that takes on a strategy that requires Congress and the President to change current laws in that investor's favor for that strategy to work over the long haul is taking on the risk of political inaction.

As such, my wife and I are of the opinion that if our incomes or filing status ever make us inelegible for Roth IRA contributions, we will contribute to non-deductable traditional IRAs. Your mileage, of course, may vary. And as ResNullus mentioned, IRAs alone will likely not be enough for a comfortable retirement.

Hope this helps,
-Chuck
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