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Greetings, All.

The following is excerpted from a booklet I am writing for my day job on various provisions of the Taxpayer Relief Act of 1997. It deals with the Roth IRA from the standpoint of contributions and rollovers of traditional IRAs. I provide it for your information and reading pleasure. Comments are welcome.

QUOTE:

General. The Roth IRA introduced by TRA 97 provides a new, powerful means to save for retirement and accumulate wealth. It's unlike any savings tool with which we're familiar. We can't get a tax deduction for making a contribution to it, but after the Roth IRA is established all contributions and earnings may be withdrawn free of taxes provided we meet a few relatively simple conditions. Unlike traditional IRAs, no withdrawals are mandatory,
and should we die our heirs will receive the entire balance tax-free. Additionally, provided our AGI is no more than $100,000 and we pay all taxes previously deferred, we may convert existing traditional IRAs to a Roth IRA. On conversion, these IRAs will also enjoy the tax-free benefits provided by the Roth.

Despite the potential for tax-free withdrawals, the Roth IRA may not be the best retirement accumulation tool for everyone. Each of us must look at our own situation to determine what course of action is best for us. Our age, the length of time before we need the money, our tax rates today versus those of tomorrow, and our net worth all play a part in deciding how to use this new option.

Contribution Comparisons. A traditional IRA is "back-loaded." This means that, subject to limits, the contribution is untaxed when it enters the IRA, but it and all earnings thereon will be taxed on withdrawal. A Roth IRA is "front-loaded," which means contributions create no deduction in today's taxes, but on withdrawal they and all earnings are received free of tax. Thus, our problem becomes one of comparing the "front-loaded" Roth IRA to the
"back-loaded" traditional IRA. Should we pay taxes at today's rates to receive tax-free proceeds tomorrow (Roth IRA)? Or should we take today's tax deduction and postpone taxes until tomorrow when we may be in a lower tax bracket (traditional IRA)?

To examine this issue, we need to look at two scenarios.

Scenario 1. John makes a tax-deductible contribution of $2,000 per year to a traditional IRA. He is considering the new Roth IRA, but must maintain the same net income he has today using the traditional IRA. John is in the 28% marginal tax bracket, which means he may only contribute $1,440 to a Roth IRA to keep his net income the same as it is by using the traditional IRA. He wonders how he would fare in the Roth IRA as compared to the
traditional IRA over time, assuming the latter will be taxed at the same marginal rate in the future. He also wonders what the comparison would be if his marginal tax rate decreases when he begins IRA withdrawals. Both investments will earn a 9% annual rate of return.

Table 1 reveals that if John's tax rate remains the same, the Roth IRA and the traditional IRA will provide the same net income after consideration of income taxes. However, if John's marginal tax rate declines at withdrawal, as it does for many retirees, then he is better off in the traditional IRA.

Annual Contributions to Roth IRA
As Compared to Traditional IRA (After Taxes)

Year Roth Before Tax After 28% After 15%
5 $9,394 $13,047 $9,394 $11,090
10 $23,847 $33,121 $23,847 $28,152
15 $46,085 $64,007 $46,085 $54,406
20 $80,301 $111,529 $80,301 $94,800
25 $132,947 $184,648 $132,947 $156,951
30 $213,948 $297,150 $213,948 $252,578
35 $338,580 $470,249 $338,580 $399,712


Table 1

Scenario 2. Assume John's circumstances are the same as before except that he will deposit $2,000 annually into the Roth IRA. To do so, he will forego contributions he was making to a regular investment account that has an after-tax return of 8.244% per year. (Note: The total return on this account is 9%, of which 30% comes from taxable dividends and 70% comes from long term capital appreciation.) For fairness, the lost principal and
growth on this additional $560 deposit must be added to traditional IRA proceeds because the foregone investment would have been available for withdrawal in later years. Assume growth in this investment account will be taxed at a long-term capital gain rate of 20% on withdrawal for a taxpayer in the 28% marginal bracket and at 10% for one in the 15% bracket. Table 2 shows the results of this approach.

$2,000 Annual Contribution to Roth IRA As Compared to Traditional IRA & Taxable Investment Account (After Taxes)

28% Bracket 15% Bracket
Ded IRA Inv Acct IRA/Inv Ded IRA Inv Acct Ded IRA
Year Roth After Tax After Tax Total After Tax After Tax Total
5 $13,047 $9,394 $2,859 $12,253 $11,090 $3,216 $14,306
10 $33,121 $23,847 $7,107 $30,954 $28,152 $7,995 $36,148
15 $64,007 $46,085 $13,420 $59,505 $54,406 $15,097 $69,503
20 $111,529 $80,301 $22,800 $103,101 $94,800 $25,651 $120,450
25 $184,648 $132,947 $36,740 $169,687 $156,951 $41,333 $198,284
30 $297,150 $213,948 $57,455 $271,403 $252,578 $64,637 $317,215
35 $470,249 $338,580 $88,237 $426,816 $399,712 $99,267 $498,979

Table 2

Notice that if John remains in the 28% marginal tax bracket when he takes his savings, then in every time period the Roth IRA will provide a greater income than the combination of the traditional IRA and the taxable investment account after both have been taxed. However, if John's tax rate declines in retirement, the Roth IRA is definitely inferior to the traditional IRA when the latter is used in concert with the taxable investment account.

Note: Based on 1997 marginal tax brackets, taxpayers in the top three tax rates (i.e., 31%, 36%, and 39.6%) are ineligible for a tax deductible traditional IRA. Those in the 39.6% bracket are also ineligible for a contributory Roth IRA. For eligible 31% and 36% taxpayers, the contributory Roth IRA is a better alternative than is the nondeductible regular IRA. Neither results in a current tax deduction, but all Roth proceeds are untaxed on
withdrawal. In the nondeductible traditional IRA, earnings are subject to taxation when withdrawn. For the 39.6% taxpayer, the only IRA alternative is the nondeductible traditional IRA.

Conclusions Regarding IRA Contributions. In choosing between a tax deductible traditional IRA and a Roth IRA, our marginal tax rate today versus that of tomorrow is important. If the tax rate declines when the money is withdrawn, those who end up in a 15% tax bracket will not benefit from Roth IRA contributions. If the tax rate stays the same in retirement, neither choice has an income tax advantage over the other during the owner's
lifetime. (Note: Because the Roth IRA passes tax free to heirs at death, it has the advantage from that standpoint.) To beat the traditional deductible IRA, an after-tax contribution to a Roth IRA must be exactly equal in dollars to that made to the traditional IRA.

Traditional IRA Conversions to a Roth IRA. TRA 97 allows taxpayers to convert traditional IRAs to Roth IRAs provided their AGI is under $100,000 in the year of conversion. (Note: Based on 1997 tax brackets, this means only those with a 15% or 28% marginal rate are eligible for a Roth IRA conversion.) No penalty applies, but ordinary income taxes must be paid on previously untaxed IRA proceeds. If the conversion occurs in 1998, the income
from the IRA must be spread equally over four years for taxation. Conversions made in 1999 or later will be fully taxed in the year they occur. If money is withdrawn from the converted IRA to pay taxes, the 10% early withdrawal penalty will apply for those younger than age 59 ½.

Scenario 3. Jane, who is younger than age 59 ½, has $50,000 in a previously untaxed IRA. She wants to rollover that IRA to a Roth IRA. Her return in either the Roth IRA or the traditional IRA will be 9% per year. Jane cannot afford to pay the income taxes due on the conversion, so she will keep enough money from the rollover to pay all taxes due in 1998 and later years. She wants to know if conversion will result in a better income for
her in retirement.

In this situation, the first problem is to determine how much she must withdraw from the traditional IRA to pay her taxes and the 10% penalty that will be due on the entire withdrawal because she is younger than age 59 ½. This can be done by using the formula W = T + 0.1W in which W is the total amount of withdrawal and T is the total amount of taxes due on the value of the converted IRA. The formula can be reduced to 0.9W = T.

If Jane is in the 15% marginal bracket and if her IRA is worth $50,000, then on conversion she will owe $$7,500 in ordinary income taxes. That means:

0.9W = T
0.9W = $7,500
W = $7,500 / 0.9 = $8,333

Jane can then withdraw $8,333 from her traditional IRA, convert the remainder ($41,677) to the Roth IRA, and have enough to pay her ordinary taxes of $1,875 over each of the next four years (a total of $7,500) plus her $833 early withdrawal penalty in 1998. The $833 is 10% of the total amount withdrawn from the converted IRA. For the purposes of this illustration, we will ignore any earnings she may receive on the amount she has retained to pay
future taxes on the rollover.

The procedure described above was used to calculate the results of converting her IRA assuming she was in the 15%, 28%, or 31% tax bracket in 1998. After-tax comparisons of the Roth IRA to the traditional IRA for each marginal tax rate are at Table 3. In every case, the Roth IRA fails to match the after-tax results of the traditional IRA. This failure is due to the lost investment opportunity on the money she withdrew from the converted IRA to pay
her taxes on the conversion.

Roth IRA Conversions Taxes and Penalty Paid from Converted IRA
15% Bracket 28% Bracket 31% Bracket
Ded IRA Ded IRA Ded IRA
Year Roth after Tax Roth after Tax Roth after Tax
5 $64,110 $65,392 $52,996 $55,390 $50,433 $53,083
10 $98,641 $100,613 $81,541 $85,225 $77,597 $81,674
15 $151,771 $154,806 $125,462 $131,129 $119,393 $125,666
20 $233,519 $238,187 $193,038 $201,759 $183,701 $193,352
25 $359,298 $366,481 $297,013 $310,431 $282,647 $297,496
30 $552,824 $563,876 $456,992 $477,636 $434,888 $457,735
35 $850,589 $867,594 $703,139 $734,903 $669,129 $704,282

Table 3

Scenario 4. Jane is in the 28% tax bracket and has a $50,000 traditional IRA she wants to convert to a Roth IRA. She will pay all taxes due on the conversion from other assets. To do so, she will withdraw the taxes due each year from a regular investment account. The account has an after-tax return of 8.244% per year. (Note: The total return on this account is 9%, of which 30% comes from taxable dividends and 70% comes from long term
capital appreciation.) For fairness, the lost principal and growth on her withdrawals must be added to the traditional IRA proceeds because had the money not been used for the Roth IRA, the investment would have been grown through the years and been available for withdrawal in retirement. Assume growth in this investment account will be taxed at a long-term capital gain rate of 20% on withdrawal for a taxpayer in the 28% marginal bracket and at 10%
for one in the 15% bracket. Table 4 shows the after-tax results of this approach for Jane if she remains in her present tax bracket of 28% or falls to a 15% marginal tax rate at the time of the withdrawal.

Roth IRA Conversions
Taxes and Penalty Paid from Taxable Investment Account
28% Bracket 15% Bracket
Ded IRA Inv Acct IRA/Inv Ded IRA Inv Acct Ded IRA
Year Roth After Tax After Tax Total After Tax After Tax Total
5 $76,931 $55,390 $14,837 $70,227 $65,392 $16,691 $82,083
10 $118,368 $85,225 $16,060 $101,285 $100,613 $18,067 $118,680
15 $182,124 $131,129 $17,384 $148,513 $154,806 $19,557 $174,362
20 $280,221 $201,759 $18,817 $220,576 $238,187 $21,169 $259,356
25 $431,154 $310,431 $20,368 $330,799 $366,481 $22,914 $389,395
30 $663,384 $477,636 $22,047 $499,684 $563,876 $24,803 $588,679
35 $1,020,698 $734,903 $23,865 $758,768 $867,594 $26,848 $894,441

Table 4

Table 4 reveals that if Jane remains in the 28% tax bracket at withdrawal, the use of other assets to pay the tax due on the conversion of her old IRA makes the Roth IRA a clear winner. The total of her traditional IRA and her investment account after taxes is less than the total for the Roth IRA. If her marginal tax rate drops to 15% when she begins withdrawal, the traditional IRA is best when those withdrawals start within 10 years. At 10 years,
the traditional IRA has a slight edge over the Roth IRA. For holding periods longer than 10 years, the Roth IRA is a better alternative.

Conclusions Regarding Roth IRA Conversions. When funds are taken from the converted IRA to pay income tax due on the conversion, the Roth IRA will be an inferior option to the traditional IRA. This holds especially true if the withdrawal to pay those taxes also results in an early withdrawal penalty. When taxes due on the conversion are taken from other taxable assets, the Roth IRA is a more attractive option. For those who remain in the
same marginal tax rate at the time of withdrawal, the Roth IRA is a clear winner. For those who drop to a lower tax bracket at withdrawal, the Roth IRA must be held for more than 10 years to beat the traditional IRA.

UNQUOTE

Regards.........Pixy









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My apologies to all. That post didn't work. I'll have to play around with the tables and repost this so the data can be read. It sure can't be deciphered easily now. I'll see what I can do to make it understandable.

Regards......Pixy
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No. of Recommendations: 8
All of the following is my rendition of TMFPixy's post...

  The tables should be much more readable... but I'm not sure if I got 
the labels on the columns of the last two tables entirely correct.
It should be easy for TMFPixy to correct any errors there (the rest of
the text should be unchanged)

  Off to write my response... ;)
    Kilmarnoch

ps.  (this is my first "preserved formatting" post, while I've observed
what they look like when other's do them I'm not sure I have all the
tricks learned yet, so i really hope this works *=).
...
...
...
Greetings, All.

  The following is excerpted from a booklet I am writing for my day job
on various provisions of the Taxpayer Relief Act of 1997.  It deals
with the Roth IRA from the standpoint of contributions and rollovers of
traditional IRAs.  I provide it for your information and reading pleasure.
Comments are welcome.

QUOTE:

General.
-------
  The Roth IRA introduced by TRA 97 provides a new, powerful means to
save for retirement and accumulate wealth.  It's unlike any savings
tool with which we're familiar.  We can't get a tax deduction for
making a contribution to it, but after the Roth IRA is established
all contributions and earnings may be withdrawn free of taxes provided
we meet a few relatively simple conditions.  Unlike traditional IRAs,
no withdrawals are mandatory, and should we die our heirs will receive
the entire balance tax-free.  Additionally, provided our AGI is no more
than $100,000 and we pay all taxes previously deferred, we may convert
existing traditional IRAs to a Roth IRA.  On conversion, these IRAs will
also enjoy the tax-free benefits provided by the Roth.

  Despite the potential for tax-free withdrawals, the Roth IRA may not be
the best retirement accumulation tool for everyone.  Each of us must look
at our own situation to determine what course of action is best for us.
Our age, the length of time before we need the money, our tax rates today
versus those of tomorrow, and our net worth all play a part in deciding
how to use this new option.

Contribution Comparisons.
------------------------
  A traditional IRA is "back-loaded."  This means that, subject to
limits, the contribution is untaxed when it enters the IRA, but it
and all earnings thereon will be taxed on withdrawal.  A Roth IRA is
"front-loaded," which means contributions create no deduction in today's
taxes, but on withdrawal they and all earnings are received free of tax.
Thus, our problem becomes one of comparing the "front-loaded" Roth IRA
to the "back-loaded" traditional IRA.  Should we pay taxes at today's
rates to receive tax-free proceeds tomorrow (Roth IRA)? Or should we
take today's tax deduction and postpone taxes until tomorrow when we
may be in a lower tax bracket (traditional IRA)?

To examine this issue, we need to look at two scenarios.


Scenario 1.
----------
  John makes a tax-deductible contribution of $2,000 per year to a
traditional IRA. He is considering the new Roth IRA, but must maintain
the same net income he has today using the traditional IRA.  John is
in the 28% marginal tax bracket, which means he may only contribute
$1,440 to a Roth IRA to keep his net income the same as it is by using
the traditional IRA.  He wonders how he would fare in the Roth IRA as
compared to the traditional IRA over time, assuming the latter will be
taxed at the same marginal rate in the future.  He also wonders what the
comparison would be if his marginal tax rate decreases when he begins
IRA withdrawals. Both investments will earn a 9% annual rate of return.

Table 1 reveals that if John's tax rate remains the same, the Roth IRA and
the traditional IRA will provide the same net income after consideration of
income taxes.  However, if John's marginal tax rate declines at withdrawal,
as it does for many retirees, then he is better off in the traditional IRA.


Table 1:
      Annual Contributions to Roth IRA
  As Compared to Traditional IRA (After Taxes)

             |       Traditional
             | Before    After    After
Year   Roth  |   Tax      28%      15%
=======================================
5       9394 |  13047     9394    11090
10     23847 |  33121    23847    28152
15     46085 |  64007    46085    54406
20     80301 | 111529    80301    94800
25    132947 | 184648   132947   156951
30    213948 | 297150   213948   252578
35    338580 | 470249   338580   399712


Scenario 2.
----------
  Assume John's circumstances are the same as before except that he will
deposit $2,000 annually into the Roth IRA.  To do so, he will forego
contributions he was making to a regular investment account that has
an after-tax return of 8.244% per year.  (Note: The total return on
this account is 9%, of which 30% comes from taxable dividends and 70%
comes from long term capital appreciation.)  For fairness, the lost
principal and growth on this additional $560 deposit must be added to
traditional IRA proceeds because the foregone investment would have
been available for withdrawal in later years.  Assume growth in this
investment account will be taxed at a long-term capital gain rate of
20% on withdrawal for a taxpayer in the 28% marginal bracket and at 10%
for one in the 15% bracket.

Table 2 shows the results of this approach.

Table 2:

      $2,000 Annual Contribution to Roth IRA As Compared to
  Traditional IRA & Taxable Investment Account (After Taxes)


     |        |       28% Bracket     |      15% Bracket
     |        |   Ded     Inv    IRA  |  Ded     Inv     IRA
     |        |   IRA    Acct     &   |  IRA    Acct      &
     |        |  After   After   Inv  | After   After    Inv
Year |  Roth  |   Tax     Tax   Total |  Tax     Tax    Total
=============================================================
5    |  13047 |   9394   2859   12253 | 11090    3216   14306
10   |  33121 |  23847   7107   30954 | 28152    7995   36148
15   |  64007 |  46085  13420   59505 | 54406   15097   69503
20   | 111529 |  80301  22800  103101 | 94800   25651  120450
25   | 184648 | 132947  36740  169687 | 156951  41333  198284
30   | 297150 | 213948  57455  271403 | 252578  64637  317215
35   | 470249 | 338580  88237  426816 | 399712  99267  498979

  Notice that if John remains in the 28% marginal tax bracket when he
takes his savings, then in every time period the Roth IRA will provide a
greater income than the combination of the traditional IRA and the taxable
investment account after both have been taxed.  However, if John's tax
rate declines in retirement, the Roth IRA is definitely inferior to
the traditional IRA when the latter is used in concert with the taxable
investment account.

Note:
  Based on 1997 marginal tax brackets, taxpayers in the top three tax
rates (i.e., 31%, 36%, and 39.6%) are ineligible for a tax deductible
traditional IRA.  Those in the 39.6% bracket are also ineligible
for a contributory Roth IRA.  For eligible 31% and 36% taxpayers, the
contributory Roth IRA is a better alternative than is the nondeductible
regular IRA.  Neither results in a current tax deduction, but all Roth
proceeds are untaxed on withdrawal.  In the nondeductible traditional
IRA, earnings are subject to taxation when withdrawn.  For the 39.6%
taxpayer, the only IRA alternative is the nondeductible traditional IRA.


Conclusions Regarding IRA Contributions.
---------------------------------------
  In choosing between a tax deductible traditional IRA and a Roth IRA,
our marginal tax rate today versus that of tomorrow is important.
If the tax rate declines when the money is withdrawn, those who end
up in a 15% tax bracket will not benefit from Roth IRA contributions.
If the tax rate stays the same in retirement, neither choice has
an income tax advantage over the other during the owner's lifetime.
(Note: Because the Roth IRA passes tax free to heirs at death, it has the
advantage from that standpoint.) To beat the traditional deductible IRA,
an after-tax contribution to a Roth IRA must be exactly equal in dollars
to that made to the traditional IRA.

Traditional IRA Conversions to a Roth IRA.
-----------------------------------------
  TRA 97 allows taxpayers to convert traditional IRAs to Roth IRAs provided
their AGI is under $100,000 in the year of conversion.  (Note: Based
on 1997 tax brackets, this means only those with a 15% or 28% marginal
rate are eligible for a Roth IRA conversion.)  No penalty applies, but
ordinary income taxes must be paid on previously untaxed IRA proceeds.
If the conversion occurs in 1998, the income from the IRA must be spread
equally over four years for taxation.  Conversions made in 1999 or later
will be fully taxed in the year they occur.  If money is withdrawn from
the converted IRA to pay taxes, the 10% early withdrawal penalty will
apply for those younger than age 59 ½.


Scenario 3.
----------
  Jane, who is younger than age 59 ½, has $50,000 in a previously untaxed
IRA.  She wants to rollover that IRA to a Roth IRA.  Her return in either
the Roth IRA or the traditional IRA will be 9% per year.  Jane cannot
afford to pay the income taxes due on the conversion, so she will keep
enough money from the rollover to pay all taxes due in 1998 and later
years.  She wants to know if conversion will result in a better income
for her in retirement.

  In this situation, the first problem is to determine how much she must
withdraw from the traditional IRA to pay her taxes and the 10% penalty
that will be due on the entire withdrawal because she is younger than age
59 ½.  This can be done by using the formula W = T + 0.1W in which W is
the total amount of withdrawal and T is the total amount of taxes due on
the value of the converted IRA.  The formula can be reduced to 0.9W = T.

  If Jane is in the 15% marginal bracket and if her IRA is worth $50,000,
then on conversion she will owe $$7,500 in ordinary income taxes.

That means:

  0.9W = T
  0.9W = $7,500
  W = $7,500 / 0.9 = $8,333

  Jane can then withdraw $8,333 from her traditional IRA, convert the
remainder ($41,677) to the Roth IRA, and have enough to pay her ordinary
taxes of $1,875 over each of the next four years (a total of $7,500)
plus her $833 early withdrawal penalty in 1998.  The $833 is 10% of the
total amount withdrawn from the converted IRA.  For the purposes of this
illustration, we will ignore any earnings she may receive on the amount
she has retained to pay future taxes on the rollover.

  The procedure described above was used to calculate the results of
converting her IRA assuming she was in the 15%, 28%, or 31% tax bracket
in 1998.  After-tax comparisons of the Roth IRA to the traditional
IRA for each marginal tax rate are at Table 3.  In every case, the
Roth IRA fails to match the after-tax results of the traditional IRA.
This failure is due to the lost investment opportunity on the money she
withdrew from the converted IRA to pay her taxes on the conversion.

Table 3:
           Roth IRA Conversions
 Taxes and Penalty Paid from Converted IRA

     |   15% Bracket   |  28% Bracket   |  31% Bracket
     |            Ded  |          Ded   |          Ded
     |            IRA  |          IRA   |          IRA
     |           after |         after  |         after
Year |  Roth      Tax  |  Roth    Tax   |  Roth    Tax
========================================================
5    |  64110    65392 |  52996   55390 |  50433   53083
10   |  98641   100613 |  81541   85225 |  77597   81674
15   | 151771   154806 | 125462  131129 | 119393  125666
20   | 233519   238187 | 193038  201759 | 183701  193352
25   | 359298   366481 | 297013  310431 | 282647  297496
30   | 552824   563876 | 456992  477636 | 434888  457735
35   | 850589   867594 | 703139  734903 | 669129  704282


Scenario 4.
----------
  Jane is in the 28% tax bracket and has a $50,000 traditional IRA she
wants to convert to a Roth IRA.  She will pay all taxes due on the
conversion from other assets. To do so, she will withdraw the taxes due
each year from a regular investment account.  The account has an after-tax
return of 8.244% per year.  (Note: The total return on this account is 9%,
of which 30% comes from taxable dividends and 70% comes from long term
capital appreciation.) For fairness, the lost principal and growth on
her withdrawals must be added to the traditional IRA proceeds because
had the money not been used for the Roth IRA, the investment would
have been grown through the years and been available for withdrawal
in retirement.  Assume growth in this investment account will be taxed
at a long-term capital gain rate of 20% on withdrawal for a taxpayer
in the 28% marginal bracket and at 10% for one in the 15% bracket.
Table 4 shows the after-tax results of this approach for Jane if she
remains in her present tax bracket of 28% or falls to a 15%
marginal tax rate at the time of the withdrawal.

Table 4:
      Roth IRA Conversions
   Taxes and Penalty Paid from Taxable Investment Account

              |      28% Bracket      |      15% Bracket
              |  Ded     Inv     IRA  |   Ded    Inv     IRA
              |  IRA     Acct     &   |   IRA    Acct     &
              | After   After    Inv  |  After  After    Inv
Year    Roth  |  Tax     Tax    Total |   Tax    Tax    Total
=============================================================
5       76931 |  55390  14837   70227 |  65392  16691   82083
10     118368 |  85225  16060  101285 | 100613  18067  118680
15     182124 | 131129  17384  148513 | 154806  19557  174362
20     280221 | 201759  18817  220576 | 238187  21169  259356
25     431154 | 310431  20368  330799 | 366481  22914  389395
30     663384 | 477636  22047  499684 | 563876  24803  588679
35    1020698 | 734903  23865  758768 | 867594  26848  894441

  Table 4 reveals that if Jane remains in the 28% tax bracket at withdrawal,
the use of other assets to pay the tax due on the conversion of her old
IRA makes the Roth IRA a clear winner.  The total of her traditional
IRA and her investment account after taxes is less than the total for
the Roth IRA.  If her marginal tax rate drops to 15% when she begins
withdrawal, the traditional IRA is best when those withdrawals start
within 10 years.  At 10 years, the traditional IRA has a slight edge
over the Roth IRA.  For holding periods longer than 10 years, the Roth
IRA is a better alternative.

Conclusions Regarding Roth IRA Conversions.
------------------------------------------
  When funds are taken from the converted IRA to pay income tax due on the
conversion, the Roth IRA will be an inferior option to the traditional IRA.
This holds especially true if the withdrawal to pay those taxes also
results in an early withdrawal penalty.  When taxes due on the conversion
are taken from other taxable assets, the Roth IRA is a more attractive
option.  For those who remain in the same marginal tax rate at the time
of withdrawal, the Roth IRA is a clear winner.  For those who drop to a
lower tax bracket at withdrawal, the Roth IRA must be held for more than
10 years to beat the traditional IRA.

UNQUOTE

Regards.........Pixy

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My question (as usual, if you've seen any of my posts on the tax board) is why the after-tax regular IRA is being calculated as though the entire tax is paid at the marginal rate? Contributions are made at the marginal rate, but withdrawals aren't necessarily so.
I suppose if the IRA withdrawals are on top of, let's say, a 401k disbursement, then they could all be at the marginal rate. As a realist, I'm not convinced that most Americans are going to have combinations of SS, 401K, IRA, inheritance savings, lottery winnings, or whatever else, pumping up their cash flow during retirement to force payouts at the marginal rates.

Any explanation as to why everyone (here, in the paper, in magazines, on television - everywhere I look) does it this way? What am I missing?
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Hi!

My husband has just changed jobs, and now has an "orphaned" 401K account with about $10K in it. We were thinking of rolling this into a Roth IRA to be able to manage the money better (the 401K is in a Manulife account - we were very unimpressed). From what I've read, it seems like a good idea, but will it realy adversely affect our taxes?

Thanks for your help -
Laura
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is it done yet?

  this is kinda long... (547 lines).  if you think this takes a while 
to read, think about how long it took to write.  =)  I should have 
prolly broken this up into 3 parts... i'll do that next time If
I get a bunch of flak about the size of this.

  hopefully there are enough errors to spark at least one reply.
and hopefully someone else understand something I wrote here.

========================================== 
to summarize (and fan the fires :) this is what I think is true:

general statements of fact: 
  - always max out your IRA options, every year!

  - if you are not eligible for a tax deductible IRA, then a roth is *the*
    best option.
  - if you are eligible for a tax deductible IRA then a traditional IRA
    *only* makes sense if you will retire in less than 20 years.
  - if you are not eligible for a Roth (lucky you), put your money into
    a traditional IRA... then evaluate a rollover to Roth when you stop
    making so much money.

MAJOR DISCLAIMER:
++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++
  I expect people to not believe these numbers... there is prolly
also going to be some misunderstanding.  Who knows all my numbers
might be completely bogus?  Please ask questions about how I
calculated a particular table if it looks fishy, and please
point out any place that my rates are bogus.  (But explain what
about them is bogus, and how you think the numbers are fishy so
I can correct them =)
++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++
END OF MAJOR DISCLAIMER.

now for the post...
=============================
TMFPixy wrote everything quoted like '>'

[tangent 1...
>Investments will earn a 9% annual rate of return...
  
  why not pick an easier number say like 10%... as long as the number
stays the same in all charts it doesn't hurt the comparison.  10% 
is a *whole bunch* easier to visually verify.  (note: even though I am
whining about it over here I will continue to use 9% in my reply ;P )
  
  all math was done to an insane number of decimal places.
...end tangent]

>Scenario 1.
>----------
>  John makes a tax-deductible contribution of $2,000 per year to a
>traditional IRA. He is considering the new Roth IRA, but must maintain
>the same net income he has today using the traditional IRA.  John is
>in the 28% marginal tax bracket, which means he may only contribute
>$1,440 to a Roth IRA to keep his net income the same as it is by using
>the traditional IRA.
  
  Okay... here is a problem.  Remember that bit about the difference
between effective tax rates and tax brackets rates?

I rambled something about: 
:The main point of this is that just because you are "in the 28% tax
:bracket" does *NOT* mean you pay 28% in taxes. being at the very top of
:the 28% tax bracket you only actually pay 22% in taxes... the lower in
:the bracket you are the lower the percent of your income you pay to tax,
:(tax ranges from 15% upto 22% in the "single's 28% bracket", and 22%
:upto 26% in the "single's 31% bracket", etc...).
  
  I really really suggest that for chart purposes people use 15.0% 
and 22.6% as the two tax rates... and maybe something in the middle
like 19.99%.  the idea that "being in the 28% tax bracket means that
you pay 28% tax" is so plain wrong, the most you will *ever* pay in the
28% bracket is effectively 22.6% and that is only if you are earning at
the _very_ top of the bracket!

---------------------------------------------------

  The "most" refund he would get for a deductible IRA contribution is
somewhere between 15% and 22% of the amount invested... that is if you
still *qualify* for a full deduction:

             your effective     $2000 deduction
you make ... tax rate is    ... is worth
==================================================
  $20000 ... 15.00000000%   ... $300.00
  $25000 ... 15.18200000%   ... $303.64
  $30000 ... 17.31833333%   ... $346.37
  $35000 ... 18.84428571%   ... $376.89
  $40000 ... 19.98875000%   ... $399.78
  $45000 ... 20.87888888%   ... $417.58
  $50000 ... 21.59100000%   ... $431.82
  $55000 ... 22.17363636%   ... $443.47
  $59750 ... 22.63682008%   ... $452.74
... the more you make the bigger the tax rebate ...

example 1:

  John makes $40k per year, so his effective tax rate is 19.99%....
if he put 2000 into a traditional IRA he would get $399.78 back in a
tax refund.

    - so he puts $2000.00 yearly into a traditional IRA
      *or*
    - so he puts $1600.22 yearly into a Roth IRA

example 2:

  John makes $20k per year, so his effective tax rate is 15.00%....
if he put 2000 into a traditional IRA he would get $300.00 back in a
tax refund.

    - so he puts $2000.00 yearly into a traditional IRA
      *or*
    - so he puts $1700.00 yearly into a Roth IRA

  so the following is my revision of Table 1, assuming that John *can*
make a fully deductible contribution and choices to make a 2000 dollars
worth of "pre tax" dollars into both types.  This uses effective tax rates
to calculate the amount put into a Roth IRA (see examples above).
(in the end: bigger numbers are better *=)

Kilmarnoch's Table 1:
      Annual Contributions to Roth IRA
  As Compared to Traditional IRA (After Taxes)

            effectively put         |
      2000 pre-tax $ into Roth IRA  |            Trad IRA
                you make            | before     after effective tax
     50,000  40,000  30,000  20,000 |   tax     15.0%   18.8%   22.6%
=========================================================================
5     10229   10438   10787   11089 |  13046 |  11089   10591   10093
10    25969   26500   27384   28152 |  33120 |  28152   26887   25623
15    50187   51212   52921   54405 |  64006 |  54405   51961   49517
20    87448   89235   92214   94799 | 111529 |  94799   90541   86282
25   144780  147739  152670  156950 | 184647 | 156950  149900  142849
30   232992  237753  245688  252577 | 297150 | 252577  241231  229885
35   368717  376252  388810  399712 | 470249 | 399712  381755  363799
                                      ^^^^^^
                            this column does not count

  Notice that the 20K per year and the 15.0% traditional IRA case match
identically... because the effective rates are the same going in and
coming out.
  So what's the result of using the effective rate?  It makes the
Roth IRA look *MUCH* less of a bad choice if your effective rate
is 15% in retirement (compared to the non-logic of the 28% -> 15%
charts).

[tangent 2...
  ...think of the chart above as a "snapshot in time"...

  Effective rates are show removing from the traditional IRA...
this is a little bogus, because it assumes either:
  - the money is taken out as one lump sum (which isn't possible at
    some of the effective rates show)
    *or*
  - the money stops earning any interest (right ;) and is taken out over a
    series of years at the effective rate show

  To *really* do the this right I need an estimated life span over
which to spread the withdrawals (from both the Roth and traditional IRA)
accounts... this would allow me to calculate the *real* effective rates
on the withdrawals from the traditional IRA each year as they are withdrawn.

tangent 3...
  how many people who make 50K and still qualify for a full deduction???
maybe 2% of the population?  ;)
... end tangents]


MAJOR DISCLAIMER:
++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++
[this was the original location of the disclaimer it applies
a *whole bunch* to the following, post]
++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++
END OF MAJOR DISCLAIMER.


Scenario 2.
----------
>  Assume John's circumstances are the same as before except that he will
>deposit $2,000 annually into the Roth IRA.  To do so, he will forego
>contributions he was making to a regular investment account that has
>an after-tax return of 8.244% per year.  (Note: The total return on
>this account is 9%, of which 30% comes from taxable dividends and 70%
>comes from long term capital appreciation.)

  I think the 8.244% return per year on the after tax account is
bogus... here's my math:

return = (rate * 70%) ... taxed at capital gains rate +
         (rate * 30%) ... taxed at effect tax rate

return = (rate * 70% * [percent that you keep after capital gains tax]) +
         (rate * 30% * [percent that you keep after max effective tax])

for someone in the 28% bracket return would be:
  7.1288058578 = (9.0 * .7 * .8) + (9 * .3 * .7736317992)

for someone in the 15% bracket return would be:
  7.965 = (9.0 * .7 * .9) + (9 * .3 * .85)

  did I miss something here?  does this make sense?

>For fairness, the lost
>principal and growth on this additional $560 deposit must be added to
>traditional IRA proceeds because the foregone investment would have
>been available for withdrawal in later years.  Assume growth in this
>investment account will be taxed at a long-term capital gain rate of
>20% on withdrawal for a taxpayer in the 28% marginal bracket and at 10%
>for one in the 15% bracket.

So in my version of table 2...
  - He is going to max out his Roth contributions, (2000 a year).
Which means to be fair to the traditional IRA...
  - he needs to put 2000 into the traditional *and*
  - then put his entire tax refund into a taxable account earning
    the "post tax" return rate.  ;)

Kilmarnoch's Table 2a:

  So what would happen if you are paying 22.6% effective taxes and
you max out as above, *then* move to the 15% effective rate at
retirement?...  *this* is the interesting part ;P

notes:
  while working the individual account earns 7.1288058578% after tax
  all other accounts earn 9%.

  while working the individual account receives 452.73 a year

  at retirement the tax rate shifts instantly to 15% effective.

     |        |  Deduc  Indiv         | Deduc  Indiv
     |        |   IRA    Acct         |  IRA    Acct
     |        | Before  Before        | After   After
Year |  Roth  |   Tax     Tax   Total |  Tax     Tax    Total
=============================================================
5    |  13047 |  13047   2796   15843 |  11090   1613   13466
10   |  33121 |  33121   6742   39863 |  28152   3981   33883
15   |  64007 |  64007  12309   76316 |  54406   7454   64868
20   | 111529 | 111529  20165  131694 |  94800  12549  111939
25   | 184648 | 184648  31249  215897 | 156951  20023  183512
30   | 297150 | 297150  46890  344040 | 252578  30988  292434
35   | 470249 | 470249  68958  539207 | 399712  47072  458325

  So this table assumes the *worst possible* tax rate (in the 28% bracket)
over the working career, then the *best possible* tax rate at retirement.
Notice how the Roth wins after 20 years?  also notice how the the
traditional wins only by $800 dollars at it's peak?  But after
35 years Roth is ahead by $12000???
  ___With___the___current___tax___scheme___ long term Roth is a no brainer.


  The higher the effective tax rate the larger the differences are
at the ends of the time spectrum.  It takes the *same* amount of time
for the Roth to "pull ahead".  (the top end of the 31% tax bracket has
an effective tax rate of 26.99117529%)... doing everything the same as
above moves the return on the taxable account to 5.7687617328%, and
moves the tax rebate to 539.82 per year.  We are still going to
assume the retiree moves straight into the 15% effective tax rate.

Kilmarnoch's Table 2c:

  post tax return rate:
    5.7687617328 = (9.0 * .7 * .8) + (9 * .3 * .2699117529)
  tax rebate:
    539.8235058000 = 2000 * .2699117529

     |        |  Deduc  Indiv         | Deduc  Indiv
     |        |   IRA    Acct         |  IRA    Acct
     |        | Before  Before        | After   After
Year |  Roth  |   Tax     Tax   Total |  Tax     Tax    Total
=============================================================
5    |  13047 |  13047   3203   16250 |  11090   2723   13812
10   |  33121 |  33121   7444   40565 |  28152   6327   34480
15   |  64007 |  64007  13058   77065 |  54406  11099   65505
20   | 111529 | 111529  20488  132017 |  94800  17415  112214
25   | 184648 | 184648  30324  214972 | 156951  25775  182726
30   | 297150 | 297150  43343  340493 | 252578  36842  289419
35   | 470249 | 470249  60577  530826 | 399712  51491  451202

note:
  - short term the difference is more in favor of traditional IRAs.
  - long term the difference is more in favor of Roth IRAs

  Also, people at the top of the 31% tax bracket aren't even eligible
for a Roth IRA... so continuing this series of graphs any higher is moot.

[tangent 4...
  I don't know the exact number of years it takes for Roth to pull ahead
but I'm interested in what it is... I'm guessing it's about 22.5 years
can any math types out there explain why that is the case?

...end tangent]


>Conclusions Regarding IRA Contributions.
>---------------------------------------
>  In choosing between a tax deductible traditional IRA and a Roth IRA,
>our marginal tax rate today versus that of tomorrow is important.
>If the tax rate declines when the money is withdrawn, those who end
>up in a 15% tax bracket will not benefit from Roth IRA contributions.

  *IF* my tables above are not completely wrong, then you need to
rewrite that conclusion.  ;P


  ahhhh... now what _about_ those conversions?
[you might want to take a break at this point... I *need* to switch
music, perhaps it's time for a drink? ;]


>Traditional IRA Conversions to a Roth IRA.
>-----------------------------------------
>  TRA 97 allows taxpayers to convert traditional IRAs to Roth IRAs provided
>their AGI is under $100,000 in the year of conversion.  (Note: Based
>on 1997 tax brackets, this means only those with a 15% or 28% marginal
>rate are eligible for a Roth IRA conversion.)  No penalty applies, but
>ordinary income taxes must be paid on previously untaxed IRA proceeds.
>If the conversion occurs in 1998, the income from the IRA must be spread
>equally over four years for taxation.  Conversions made in 1999 or later
>will be fully taxed in the year they occur.  If money is withdrawn from
>the converted IRA to pay taxes, the 10% early withdrawal penalty will
>apply for those younger than age 59 ½.

some more general statements of fact:
  - if must use IRA funds to convert don't even think about it
    (the tax twits will slap you hard).
  - if you can convert to a Roth IRA with outside funds do it.


  Thanks to those "facts" above I'm tossing out Scenario 3... which has
someone trying to use IRA funds for the rollover.  Most people who
"should" rollover must save money outside the IRA to do the rollover
with, the rollover is not worth it otherwise.


  I would prefer to stick to lump sum rollover examples, because provided
that you stay in the same tax bracket you will *always* pay more on a
lump sum rollover than a 4 year spread out rollover and the spread rollover
is only available in this one year.  So if a lump sum rollover makes sense
then a spread out rollover will always make "more" sense.  I will also
assume that *all* of the amount is taxable, simply because that is the
worst case example for the Roth.  Despite both disadvantages the Roth
rollover is a no brainer...

[tangent 6...
  I would like for all of the following examples to use 2000 per year
contributions to the resulting Roth ... and 2000 + rebate to the
non-rolled over traditional IRA (but my head is beginning to hurt ;)
so I'm going to keep it simple: no contributions to any account after
roll over (i think donations might give the traditional account an slight
short term advantage).
...end tangent]


>Scenario 4.
>----------
>  Jane is in the 28% tax bracket and has a $50,000 traditional IRA she
>wants to convert to a Roth IRA.  She will pay all taxes due on the
>conversion from other assets. To do so, she will withdraw the taxes due
>each year from a regular investment account.
  [the after 8.244% tax return rate was bogus in the example above]

side note:
  Jane is currently about 34 years old... (starting at 21, 13 years of
max contributions with a 9% return results in $50k), so 25 year forecasts
put her at the "penalty free withdrawals" age.  35 years puts her at the
point that she *must* start making withdrawals from a traditional IRA.

Kilmarnoch's Table 4a:
      Roth IRA Conversions
   Taxes and Penalty Paid from Taxable Investment Account

  taxable account returns 7.1288058578%  (worst 28% bracket return)

             22.6% effective at conversion
              |   Ded      Inv      IRA  |  22.6% |  15.0%
              |   IRA      Acct      &   |  Total |  Total
              |  Before   Before    Inv  |  After |  After
Year    Roth  |   Tax      Tax     Total |   Tax  |   Tax
===========================================================
0       50000 |   50000   14630    64630 |  50000 |   54935
5       76931 |   76931   20643    97574 |  75486 |   82937
10     118368 |  118368   29127   147495 | 114106 |  125370
15     182124 |  182124   41099   223223 | 172692 |  189739
20     280221 |  280221   57992   338213 | 261652 |  287481
25     431154 |  431154   81827   512981 | 396858 |  436033
30     663384 |  663384  115460   778844 | 602538 |  662017
35    1020698 | 1020698  162915  1183613 | 915680 | 1006071


  Roth is a no brainer win after 10 years for level, and 30 years
for 22.6 -> 15.0 % changes in tax rates.


  Well now... 50000 as a lump sum is going to really raise the AGI...
which means it might "push" this poor person into the higher 31% bracket!
So let's do the math as if it does:


Kilmarnoch's Table 4b:
      Roth IRA Conversions
   Taxes and Penalty Paid from Taxable Investment Account

notes:
  taxable account still returns 7.1288058578%  (worst 28% bracket return)

  but the effective tax rate when the conversion happens is 26.99117529%
this is the *highest effective tax rate* in the 31% tax bracket!
  that means that she needs $18484.87 at the time of the rollover.

the math:
  needed to rollover = [desired in roth] / [portion you keep after tax]
  68484.8717926992 =  50000 / (1.0 - .2699117529)

to check the math:
  [amount in roth] = [amount taxed] * [amount you keep after tax]
  50000 =  68484.8717926992 * .7300882471


             27.0% effective at conversion
              |   Ded      Inv      IRA  |  22.6% |  15.0%
              |   IRA      Acct      &   |  Total |  Total
              |  Before   Before    Inv  |  After |  After
Year    Roth  |   Tax      Tax     Total |   Tax  |   Tax
===========================================================
0       50000 |   50000   18484    68484 |  52981 |   58211
5       76931 |   76931   26081   103012 |  79693 |   87560
10     118368 |  118368   36800   155168 | 120042 |  131892
15     182124 |  182124   51926   234050 | 181068 |  198942
20     280221 |  280221   73269   353490 | 273471 |  300466
25     431154 |  431154  103383   534537 | 413534 |  454356
30     663384 |  663384  145876   809260 | 626069 |  687871
35    1020698 | 1020698  205833  1226531 | 948883 | 1042551


  wow?!?  Notice the traditional beats Roth hands down over time
for the 27% conversion -> 15% retirement?  how is that?


[tangent 5...
  the test mentioned here was discovered as I was writing my reply
    I've developed a headache and don't want to test all these numbers
    with a different rate of return, but I suspect that the higher
    the return rate the more a Roth helps you (because it saves
    you more in tax each year)
...end tangent]

the 35 year test:
  [convert test] = [conversion effective rate] -
                   [retirement effective rate] - [investment growth rate]

  if convert test is less than zero you should do the conversation.
  if convert test is grater than zero you should not convert.

in the first 22.6 -> 15.0 example:
  convert test = -1.36317992 = 22.63682008 - 15.0 - 9.0
  difference between roth and traditional = 1.0145387353 = 1020698 / 1006071
  a roth IRA earns 101.45387353% of what a traditional would (winning).

in the second 27.0 -> 15.0 example:
  2.99117529 = 26.99117529 - 15.0 - 9.0
  difference between roth and traditional = .9790389151 = 1020698 / 1042551
  a roth IRA earns 97.90389151% of what a traditional would (lossing).


  You should notice that the roth is favored more over time... because
my little "covert test" formula is off by some factor in favor of the
roth.  if a math type would like to explain how/why that is I'm all
ears.  =)


  I'm sure that my test as described above is not 100% correct.  But I am
also *SURE* there is some formula that takes into account the short term
and long term periods and answers one of the following questions (the
formula *must* exisit):

  "How many years will it take, with an effective conversion rate of [A],
    with a tax able account growth rate of [B] and a non-taxable growth
    of [C], for a roth IRA to beat a traditional IRA, if at retirement
    my effective tax rate is [D]?"

    *or*

  "After [A] years, how much does a roth beat a traditional, when the
    effective conversion rate of was [B], a tax able account growth
    rate is [C], non taxable growth is [D], and at retirement my
    effective tax rate is [E]?"

  anyone like word problems?  *=)

Later,
  -- Kilmarnoch


ps.
  What I would really like to talk about is what people think congress
is going to do about the SS and debt problems in the future... how they
handle that is going to have a major effect on what the best place to
store our money is.

  If the simply crank up the tax rates but mostly keep the current system
(highest bracket in the mid-50's ... 45%, 35%, 30%, lowest bracket at
20%)... Roth will win hands down.  (provided it retains it tax free nature =)
  If they add a national sales tax of some sort, and do away with income
tax (right next pipe dream), traditional wins.  If they don't do away
with income tax and add a sales tax, roth wins.

  I know it's alot of speculation, but I also know *SOMETHING* is going to
happen before I reach 50... and I'm concerned.  =)

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No. of Recommendations: 0
tc001 wrote:
<<My question (as usual, if you've seen any of my posts on the tax board) is why the after-tax regular IRA
is being calculated as though the entire tax is paid at the marginal rate? Contributions are made at the
marginal rate, but withdrawals aren't necessarily so.>>

actually nothing is done at the marginal rate... everything is done at the effective rate. But the effective rate varies based on the exact dollar amount you make, and it is alot harder to explain to people who think of themselves "in the 28% bracket".

I think everyone is using the marginal rate because it is easy to do. I also think the results are useless. ;P


As far as the rate at retirement matching the rate at contribution, I think anyone who is *planning* for their retirement is not going to take too much of a tax bracket reduction after retirement. Most people who care what happens to themselves after retirement have a large amount of money saved away outside an IRA. Have you thought about what is going to happen to the tax rates when SS becomes a problem? Are you expecting tax rates to go *down* long term???

-- Later
Kilmarnoch


I hope to be well above the 15% tax bracket in retirement:

save 10,000 a year earning 10%:
- year 1: 11000 saved
- year 10: 175311 saved
- year 20: 630024 saved
- year 30: 1809434 saved
- year 40: 4868518 saved

at 10% I'm making $442592 a year... even with inflation at 5%, I think that will be in the middle tax bracket. But this is a dream right now... (not too) far from a reality. =)


Now imagine what that would be like with all of that amount inside a tax *free* Roth IRA?

Max out your 401K each year, and max out a Roth each year, periodically convert the 401K to a Roth and pay for the convertion with outside money. The result is you can put 12K a year into a tax *free* investment.
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No. of Recommendations: 0
Pixy Wrote about converting from regular IRA to Roth IRA
and paying the tax from the IRA.
<<. In every case, the Roth IRA fails to match the after-tax
results of the traditional IRA. This failure is due to the lost
investment opportunity on the money she withdrew from the
converted IRA to pay her taxes on the conversion.>>

<<Conclusions Regarding Roth IRA Conversions. When
funds are taken from the converted IRA to pay income tax
due on the conversion, the Roth IRA will be an inferior option
to the traditional IRA. This holds especially true if the
withdrawal to pay those taxes also results in an early
withdrawal penalty.>>

You assume that whenever taxes are due they will be
paid at the same rate. In this case the difference between
remaining with a traditional IRA and converting to the ROTH,
paying taxes from the IRA, is due ONLY to the 10%
penalty. Without the 10% penalty staying it's a wash.

This is important. Some 60-70 year olds may want
to convert to a ROTH to avoid mandatory distributions
or for estate planning if they die before the IRA is spent.
Given your assumptions** there is no reason not to do
this.

** The assumption of constant tax rates may be invalid.
But a 70 year old has a lot better chance of predicting
congressional whim for 20 years than a 40 year old has
for 50 years.

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No. of Recommendations: 0
Tc001 wrote:
Any explanation as to why everyone (here, in the paper, in magazines, on television - everywhere I look) does it this way? What am I missing?

Tc:
Most advise is based on the situation the advisor wishes
he were in. The better advise is based on the situation the
advisor is actually in. That's why it's Foolish to think
for yourself.

The median household income in the US is around
$40,000. Good advice for the majority (for whom the
28% tax bracket is a distant rumor) is sadly lacking.
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No. of Recommendations: 0
Kilmarnoch,

<<All of the following is my rendition of TMFPixy's post...

The tables should be much more readable... but I'm not sure if I got
the labels on the columns of the last two tables entirely correct.
It should be easy for TMFPixy to correct any errors there (the rest of
the text should be unchanged)>>

All is correct. Thanks for the assist and the tips on how to do this you sent me via off-board message.

Regards....Pixy
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No. of Recommendations: 0
Greetings, TC001, and welcome.

<<My question (as usual, if you've seen any of my posts on the tax board) is why the after-tax regular IRA is being calculated as though the entire tax is paid at the marginal rate? Contributions are made at the marginal rate, but withdrawals aren't necessarily so.
I suppose if the IRA withdrawals are on top of, let's say, a 401k disbursement, then they could all be at the marginal rate. As a realist, I'm not convinced that most Americans are going to have combinations of SS, 401K, IRA, inheritance savings, lottery winnings, or whatever else, pumping up their cash flow during retirement to force payouts at the marginal rates.

Any explanation as to why everyone (here, in the paper, in magazines, on television - everywhere I look) does it this way? What am I missing?>>

I see that Kilmarnoch gave you an answer from his perspective, so I'll give you mine. Needless to say, we don't see eye-to-eye on this issue. Take my word for it, our friend Kilmarnoch is wrong. :-P

Most analyses use the marginal rate not so much because it's "easy" but because they are treating the contribution as one made from incremental income or from the last dollars earned and taxed. They do the same for withdrawals. In other words, they don't say withdrawals puts a person in that bracket, but that the person is already there and the withdrawals represent the last dollars of income.

The effective rate used by Kilmarnoch is a legitimate approach if you ignore net income and instead look at income before taxes. I use marginal rates for contributions because those dollars are the last ones taxed. I use it for withdrawals as well because I have to assume something in a scenario. I assume a person would be in a particular tax bracket regardless of the withdrawal. Therefore, I treat withdrawals as the last dollars of income taken, and those dollars would be taxed at the marginal rate.

On the contribution issue, I think it's no contest. Use of marginal rates is appropriate. On the withdrawal issue, the answer is a toss up based on the assumptions regarding total income in the case under consideration. In that case, either approach is appropriate and realistic provided the assumptions are stated.

Regards……Pixy

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Greetings, Laura, and welcome.

<<My husband has just changed jobs, and now has an "orphaned" 401K account with about $10K in it. We were thinking of rolling this into a Roth IRA to be able to manage the money better (the 401K is in a Manulife account - we were very unimpressed). From what I've read, it seems like a good idea, but will it realy adversely affect our taxes?>>

If it's already in a traditional IRA and if you roll that to a Roth IRA in 1998, you must declare one-fourth of the accounts value as income over the next four years and pay taxes on that amount each year. In 1998, that means you'll have about $2.5K to declare as extra income. In a 28% marginal tax bracket, that means you would pay an extra $700 in taxes to Uncle Sam this year. Only you can say whether or not that has an adverse impact on you. My guess is if you leave the rollover money alone for ten or more years, you will be money ahead. Read my posts and Kilmarnoch's posts on this issue to see why.

Regards……Pixy
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Kilmarnoch,

Interesting analysis. You are obviously an advocate of effective tax rates, but you missed a very key point that negates totally your comments about my use of marginal tax rates. Remember, I said:

<< John makes a tax-deductible contribution of $2,000 per year to a traditional IRA. He is considering the new Roth IRA, but must maintain the same net income he has today using the traditional IRA. John is in the 28% marginal tax bracket, which means he may only contribute $1,440 to a Roth IRA to keep his net income the same as it is by using the traditional IRA.>>

In your argument for using effective rates, you said:

<< John makes $40k per year, so his effective tax rate is 19.99%....if he put 2000 into a traditional IRA he would get $399.78 back in a tax refund.>>

Both statements are true. There's a big difference between what a person "makes" before taxes and what he "nets" after taxes. If John adds $2K to his current taxable income in my scenario, he will pay $560 in additional income tax for the privilege, not an effective $399.78 as you would have it. To keep a net income of $40K, he's got to pay taxes of $560 or his net income must drop. If his taxable income using the traditional IRA is $51,105, he nets $40K. If he foregoes the IRA deduction for the Roth, his taxable income jumps to $53,105. With the deductible IRA, he pays $11,105 in taxes. Without it, will his tax bill jump to $11,105 + $399.78 = $11,504.78 or to $11,105 + 560 = $11,665? The Tax Code says the latter. Therefore your effective rate is meaningless in the scenario I have outlined.


As to the imputed rate of return on the $560 foregone annual investment, you said:

<< I think the 8.244% return per year on the after tax account is bogus... here's my math:

return = (rate * 70%) ... taxed at capital gains rate + (rate * 30%) ... taxed at effect tax rate >>

I'm sure it makes sense to you to use effective tax rates here, but it doesn't to me. Again, the example has John in the 28% marginal rate. If the $560 per year earned a taxable dividend during the year, because of his marginal rate John would pay $0.28 on each dollar earned. You would have him pay something less based on the effective rate on his total income. To me, that's nonsense. After an individual has crossed the lower level of a tax bracket, each incremental dollar earned will be taxed at that bracket's rate and NOT the effective rate. The latter only has a bearing when overall income comes into play, not incremental income. In fact, each added dollar of income changes the overall effective tax rate. But until you cross into the next higher tax bracket, it doesn't change the marginal rate. Hence, I don't think my use of marginal rates in this computation is either "bogus" or inappropriate. But I do think your use of effective rates is. <g>

I'm still looking at the second part of your analysis, so I haven't a definitive comment to make on that. But I do have some clarifications as to why I took the approach I did. First, I avoided mention of age because I didn't want to get into the issue of minimum required distributions from the traditional IRA at age 70 ½. Instead, I wanted to present a generalized comparison as to growth after taxes. That's also why I treated the taxation of ultimate values on the traditional IRA as I did and ignored additional growth based on annual withdrawals. I was attempting to show the comparative effect of growth in the two accounts. Relatively speaking, a specific withdrawal pattern would not change the comparison. If both the Roth and traditional IRA continued compounding at the same rate, if a withdrawal was the same dollar amount from both accounts, and if the tax rates were as assumed, then the relationship of the accounts would be the same as that in the comparison I made for the "lump sums." Admittedly, that's not the best way to make the comparison, but it keeps things on even terms without a lot of mathematical gyrations.

I commend you on your work. You have shown (as I hope I have) that there's more to the Roth issue than first meets the eye. In fact, because Congress loves to tinker with taxes and will do more of that in the future, the time comparisons either of us make are based on assumptions that may be totally invalidated by this time next year. Therefore, any projection beyond five years is best taken with a grain of salt.

Regards…….Pixy
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Kilmarnoch,

<< actually nothing is done at the marginal rate... everything is done at the effective rate. But the effective rate varies based on the exact dollar amount you make, and it is alot harder to explain to people who think of themselves "in the 28% bracket".

I think everyone is using the marginal rate because it is easy to do. I also think the results are useless. ;P >>

That's absurd, and I know you know that. Many things are done at the marginal rate because every added dollar of income within a bracket costs you that bracket's rate in added taxes. I refuse to believe you're so blinded by love of the effective rate that you can't see that, so why do you persist in ignoring it?

<<As far as the rate at retirement matching the rate at contribution, I think anyone who is *planning* for their retirement is not going to take too much of a tax bracket reduction after retirement. Most people who care what happens to themselves after retirement have a large amount of money saved away outside an IRA. Have you thought about what is going to happen to the tax rates when SS becomes a problem? Are you expecting tax rates to go *down* long term??? >>

Another point we can agree on. Rates will go up. How? Who knows. Watch for the worst in the way of a flat tax, value added tax, or combination. In that case, we'll all feel the crunch.

Regards……Pixy
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>>>Most people who care what happens to themselves after retirement have a large amount of money saved away outside an IRA.<<<

Kilmarnoch,

Why do you say that? By outside an IRA, are you referring to 401k?

orangeblood
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Vtaeger,

<<You assume that whenever taxes are due they will be
paid at the same rate. In this case the difference between
remaining with a traditional IRA and converting to the ROTH,
paying taxes from the IRA, is due ONLY to the 10%
penalty. Without the 10% penalty staying it's a wash.>>

Great catch. I failed to think that through. It applies only if the penalty is paid, all other things being equal. I'll have to redo the conclusion section to say that.

<<** The assumption of constant tax rates may be invalid. But a 70 year old has a lot better chance of predicting congressional whim for 20 years than a 40 year old has for 50 years.>>

Absolutely correct. It's the one major sticking point I have about ANY long-term projections, Roth or otherwise. Things can change tomorrow, and then everything is out the window.

Regards…..Pixy
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Vtaeger,

<<Most advise is based on the situation the advisor wishes
he were in. The better advise is based on the situation the
advisor is actually in. That's why it's Foolish to think
for yourself.>>

LOL.

<<The median household income in the US is around
$40,000. Good advice for the majority (for whom the
28% tax bracket is a distant rumor) is sadly lacking.>>

True. Fortunately, for Fools these ARE thoughts to keep in mind. We don't follow the flock, and I KNOW I'll have to worry about tax rates in retirement. If I drop into the lower end, I will have failed miserably in my wealth accumulation goals. And I intend to make my children very happy on my demise even after whooping it up in my later years.

Regards….Pixy

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Kilmarnoch WROTE,
<< actually nothing is done at the marginal rate... everything is done at the effective rate. >>
and Pixy REPLIED,
<< That's absurd, and I know you know that. Many things are done at the marginal rate because every added dollar of income within a bracket costs you that bracket's rate in added taxes.>>

I know that all contributions are made at the marginal rate, as I stated in my original post. This fact *cannot* be disputed. So at least I can agree with one of you, but only on the numbers on IRA contributions and growth.

Kilmarnoch WROTE,
<<I think anyone who is *planning* for their retirement is not going to take too much of a tax bracket reduction after retirement. Most people who care what happens to themselves after retirement have a large amount of money saved away outside an IRA. Have you thought about what is going to happen to the tax
rates when SS becomes a problem? Are you expecting tax rates to go *down* long term??? >>
and Pixy REPLIED,
<<Another point we can agree on. Rates will go up. How? Who knows. Watch for the worst in the way of a flat tax, value added tax, or combination. In that case, we'll all feel the crunch.>>

I can see the basis of these comments, but cannot agree with the conclusions. First, everyone cares what will happen to themselves during retirement (excluding some type of self-destructive mental illness), but I think, statistically, the numbers on American savings, in or out of an IRA, shows a different picture about how they are planning for it.

Just look through the Fool message boards (assuming this is where the more financially intelligent people gather) and see how many people have credit card balances that are bigger than their savings (I'm only half-joking with this comment). It gets worse among the general population, many of whom still believe that SS will provide for their retirement (which it was never designed to do in the first place). Since I doubt that the average American will have a high six figure nest egg, I don't think it's true that they will be in the same or a higher effective tax bracket.

More important is the suggestion about rising taxes. You both argue that SS is in trouble, so rates will rise. I may be very wrong, but I don't think there is any SS tax on IRA withdrawals. Therefore, an SS rate increase will hit the workers, not the retirees. This doesn't result in a higher taxes for retirees.

OK, let's assume that the SS mess will be resolved by higher earned income taxes, rather than higher SS taxes. Once again, the workers pay earned income tax. Withdrawals from an IRA are not earned income. Again, the tax burden occurs during the contribution phase and does not produce higher taxes during the withdrawal phase.

Fine, you say. Let's assume that the SS mess will be fixed by taxing all income and not just earned income. Now you've just admitted that Congress has the capacity to undermine the concept of the Roth IRA by taxing its distributions. Remember, SS payments were NOT taxed for many years. To argue that taxes must go up to fix SS, and that the people with Roth IRAs are the anointed holy ones who will cleverly escape the tax demons because of a law passed 30 years before they retired, seems naive. How many tax breaks has Congress created and then eliminated during U.S. history?

Finally, the alternate tax method arguement about some type of consumption tax is thrown in. Once again, does this make a Roth IRA distribution better or does it really argue against the Roth? With a national sales tax, when you buy a television nobody is going to ask if it's being paid for with Roth funds, thereby making it free from tax :)
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TC001,

Super post!!!!!!!! And well-argued. We can all speculate on the shape, type and impact of real and imagined changes until we're blue in the face. Until it happens, though, we gotta live with what is and plan accordingly.

You said:

<<I know that all contributions are made at the marginal rate, as I stated in my original post. This fact *cannot* be disputed. So at least I can agree with one of you, but only on the numbers on IRA contributions and growth.>>

It's me! It's me! :-P

You also said:

<< Finally, the alternate tax method arguement about some type of consumption tax is thrown in. Once again, does this make a Roth IRA distribution better or does it really argue against the Roth? With a national sales tax, when you buy a television nobody is going to ask if it's being paid for with Roth funds, thereby making it free from tax :) >>

Not just the Roth is involved here. ALL savings will be affected. Those of us who tried to save will be hit the worst because instead of spending it all early, we tried to put some aside for when it really counted. In a traditional IRA, you'll get hit as well, so if that occurs, who wins besides Uncle Sam?

Regards…..Pixy
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Kilmarnoch WROTE,
<<I think anyone who is *planning* for their retirement is not going to take too much of a tax bracket reduction after retirement. Most people who care what happens to themselves after retirement have a large amount of money saved away outside an IRA.>>

orangeblood ASKED about the above,
<<Why do you say that? By outside an IRA, are you referring to 401k?>>

I said that because I guess most people have not been putting away 2000 a year for 40 years, and would really *need* to have some additional fund to live on after retirement. I was thinking of both 401k and other work related retirement plans (pick a number). As well as just taxable savings, basically an emergency fund available throughout their life (available before 59 1/2 :), something that wasn't tied up in red tape.

The phrase "people who care about what happens to themeselves" was uncalled for... too harsh. I was being too idealistic... I'm sure many people care what happens to themselves but haven't actually suceeded in saving for retirement, (as tc0001 points out below). The phrase "large amount of money" is way too vague.

me again:
<<Have you thought about what is going to happen to the tax rates when SS becomes a problem? Are you expecting tax rates to go *down* long term??? >>

and Pixy REPLIED,
<<Another point we can agree on. Rates will go up. How? Who knows. Watch for the worst in the way of a flat tax, value added tax, or combination. In that case, we'll all feel the crunch.>>

then tc001 REPLIED to both,
<<I can see the basis of these comments, but cannot agree with the conclusions. First, everyone cares what will happen to themselves during retirement (excluding some type of self-destructive mental illness), but I think, statistically, the numbers on American savings, in or out of an IRA, shows a different picture about how they are planning for it.>>

Very valid point.

On the tax issue, I think you're right that SS tax is only on worker earned income. I didn't write out the thought: I read the work force is going to be so small compared to the retired SS population around 2025 that SS tax would need to be in the 50% range to keep the current system afloat. I have no refernces for that statement, so it isn't a "fact". Using that as a internal basisi of thought I've expected funding for the SS system to come out of other tax sources ... since currently the biggest tax base is personal income tax, I figured that will be the first place they tap.

tc001:
<<Fine, you say. Let's assume that the SS mess will be fixed by taxing all income and not just earned income.>>

Since the "simplest solution" would to just raise the current tax brackets, that's what I think will happen. They would need to specifically rewrite the Roth IRA laws to make that taxable income (yeah not a challenge if you hold the pen :), if they over look that exisiting Roth's will get a big immediate bonus over traditional IRA's (when the brackets move up). If they turn Roth's into taxable accounts, won't they start tapping other sources of tax deferred income (401k, traditional IRA, etc)?

tc001:
<<Finally, the alternate tax method arguement about some type of consumption tax is thrown in. Once
again, does this make a Roth IRA distribution better or does it really argue against the Roth?>>

Why would they wipe out the current tax system to put another in place? They would take an enormise risk removing the current income tax system and replacing it with a sales tax system at the very time they *need* to increase renevue. I was thinking they would make a national sales tax *AND* continue to do income tax... tax money on both ends, in and out. ...means more revenue right? =)

Switching from one means of taxing to another will cause short term chaos, gradually turning up rates on one form while reducing rates on another is the safest way?

*IF* they did both forms of tax, Roth and traditional IRAs would be on the same footing they are now. If they replace income tax with sales tax *every* tax deffered, tax free, reduced tax investment would suddenly be much less valuable... Roths would be hurt the hardest (no doubt). I think there would be short term financial chaos as people transfer their money from formerly tax-exempt investments into higher yielding (formerly taxable) investments.

TTFN,
--Kilmarnoch
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TMFPixy wrote:
<<Hence, I don't think my use of marginal rates in this computation is either "bogus" or inappropriate. But I do think your use of effective rates is. <g> >>

That pretty much sums up my whole post, doesn't it?

It looks like the way I was trying to use effective rates for rebate calculations is all wrong, it turns out the different between my "effective rebate" and the real $560 rebate is always accounted for in the *change* in effective rate (deducting versus not deducting). Since I was using the same idea in that entire post I expect anyplace that involved a rebate is completely wrong.

<<You are obviously an advocate of effective tax rates>>

Actually I've not an offical advocate... haven't received my membership badge yet =). I hopped on that idea about a week ago... from you reply I see that it doesn't work some in places I've been using it, I need to think about it more.

The last few charts that didn't involve rebates (that used effective rates) might still be useful...

I'll still try to figure out a "roth-ify" formula based on time, tax rates and return rates... one must exist.

================

there is something that still might be worth asking:

given a taxable investment earning 9%, 30% is dividend income (taxed at 28% marginal rate), 70% is long term capital growth (20%).

I wrote:
<<I think the 8.244% return per year on the after tax account is bogus... here's my math:

return = (rate * 70%) ... taxed at capital gains rate + (rate * 30%) ... taxed at effect tax rate >>

TMFPixy replied,
<<I'm sure it makes sense to you to use effective tax rates here, but it doesn't to me. Again, the example has John in the 28% marginal rate. If the $560 per year earned a taxable dividend during the year, because of his marginal rate John would pay $0.28 on each dollar earned.>>

okay I agree, 28% on the dividends (not 22.6) and 20% on the capital gains. wouldn't that mean a still lower the after tax yield on a 9% investment:

return = (yield * 70%) ... taxed at capital gains rate + (yield * 30%) ... taxed at marginal rate.

so something like:
6.984 = (9 * .7 * .8) + (9 * .3 * .72)

after all if you are earning 9% and you get taxed at 20% on the whole investment you keep 80% of the "growth"... 9 * .8 == 7.2. How can someone who is being taxed at 20% and 28% expect a higher 8.244% return?

(8.244 / 9 = 91.6%, meaning the gov't only gets 8.4% of the yearly yield??? ... i must be missing something.)

Thanks
--Kilmarnoch
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ARGH! If I could only edit my last post.

<<return = (yield * 70%) ... taxed at capital gains rate + (yield * 30%) ... taxed at marginal rate.

so something like:
6.984 = (9 * .7 * .8) + (9 * .3 * .72)

after all if you are earning 9% and you get taxed at 20% on the whole investment you keep 80% of the "growth"... 9 * .8 == 7.2. How can someone who is being taxed at 20% and 28% expect a higher 8.244%
return?>>

change *investment* to *yearly gain*

... if you are earning 9% and you get taxed at 20% on the yearly gain you keep 80% of the "growth"...

I suppose I should put that example to numbers:

investment: $1000
pre-tax rate: 9%

gain: $90
30% of gain is from dividends: $27
70% of gain is from capital growth: $63

tax on dividends (at 28%): $7.56
tax on capital growth (at 20%): $12.6

total tax: $20.16
total growth: $69.84

percent government takes: 22.4%
percent you keep: 77.6%

you keep 77.6% of the 9% gain: 6.984%

Nap time now!
--Kilmarnoch
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Kilmarnoch,

<<return = (yield * 70%) ... taxed at capital gains rate + (yield * 30%) ... taxed at marginal rate.

so something like:
6.984 = (9 * .7 * .8) + (9 * .3 * .72)

after all if you are earning 9% and you get taxed at 20% on the whole investment you keep 80% of the "growth"... 9 * .8 == 7.2. How can someone who is being taxed at 20% and 28% expect a higher 8.244%
return?>>

change *investment* to *yearly gain*

... if you are earning 9% and you get taxed at 20% on the yearly gain you keep 80% of the "growth"... >>

No, that won't work in this case because the 20% doesn't get assessed until you sell. The question then becomes, when does that happen? In my scenario, it was at the point where withdrawals would begin. Your formula would make it annually. Can't do that and get capital gains rates, but I suppose you could say every 18-months. Or maybe every two years, or three, etc. That gives rise to did you sell all or part? The questions go on and on. I took the easy way and said it was a buy and hold until the end of 5 years, 10 years, etc. At the end of that period, I would assess the capital appreciation the 20% tax.

Your formula, by applying the tax annually, loses the compounding effect of the yet-to-be-taxed dollars. Example: I buy a share of stock today for $100, and it appreciates at 10% (all capital gain) per year for 20 years. At the end of that time the share is worth $$672.75, and after the one-time 20% capital gains tax I would net $$538.20. Under your formula the compounding to the net would be at 10% * 0.8 = 8% to end up at $466.10. You short change the growth that way.

Regards…..Pixy


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TC001 wrote:
<< Finally, the alternate tax method arguement about some type of consumption tax is thrown in. Once again, does this make a Roth IRA distribution better or does it really argue against the Roth? With a national sales tax, when you buy a television nobody is going to ask if it's being paid for with Roth funds, thereby making it free from tax :) >>

Pixy replied:
<<Not just the Roth is involved here. ALL savings will be affected. Those of us who tried to save will be hit the worst because instead of spending it all early, we tried to put some aside for when it really counted. In a traditional IRA, you'll get hit as well, so if that occurs, who wins besides Uncle Sam?>>

The affect of a switch from income tax to consumption
tax affects traditional IRAs, ROTH IRAs and after tax
savings differently. Lets assume a switch to consumption
taxes with no increase in Government spending, so the
consumption tax replaces the income tax dollar for dollar.
---
Taxable investments fair best with the change.
Under current law they are taxed when earned, as they
grow and finally when capital gains are relized at the end..
Under a consumption tax they get to compound tax free,
but are taxed when spent. Over 10 years or more the extra
tax free compounding more than makes up for any possible difference between the existing capital gains rate and the consumption tax rate. With less than 10 years you
probably have time to take evasive action.

The earlier the change is made the better they fair, since a
switch to consumption tax allows them the compound
tax free, which is an unexpected 'windfall'.
----
Deductable IRAs (and 401(k)s) come out unscathed. The money was not taxed when earned, will not be taxed at
withdrawal and will be taxed when spent. It's only taxed
once as 'promised'. The tIRA is treated fairly and as expected.

Non-deductable IRAs are taxed when earned and when
spent. They are taxed twice, which may not be fair but it
is expected.

It's been argued that the IRA is tied up in an
'underperforming' account and would perform better
as a taxable investment. Unless you speculate on
margin, short sales or collectables, an IRA can be
invested anywhere. The only underperformance is
due to the custodial fee, this can be as little as $10,
a trivial amount for a $10,000+ account..
---
ROTH IRAs get hammered. A switch to consumtion
tax means they get taxed twice, when earned and when
spent. This is both unexpected and unfair.

I can't remember who said it first but:
"An old tax is a fair tax." The congress critters should stop
grandstanding.
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Vtaeger,

Good post!

<<The affect of a switch from income tax to consumption
tax affects traditional IRAs, ROTH IRAs and after tax
savings differently. Lets assume a switch to consumption
taxes with no increase in Government spending, so the
consumption tax replaces the income tax dollar for dollar.>>

Big assumption IMHO. While I see some kind of national VAT or sales tax, I don't see it standing alone. Far from it, in fact. I think our fearless leaders will implement some kind of consumption tax in conjunction with an insidious income tax (applicable only to the "rich" of course) at a lower rate than today's. In that case, my statement stands. ALL savings will be affected adversely, albeit at differing levels.

Regards….Pixy
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I can't find the article I wanted to reply to, so I'm sticking this in here, on its own. I think Pixy explained somewhere why all the money was withdrawn at once in the examples. It does make the explanation clearer, but I think it's too simplistic in a very important way.

If I want $5000 of income from a traditional IRA, I have to take out $5000 + $1400, if I'm in the 28% bracket, vs. $5000 from the Roth IRA. So, if you take into account the fact that withdrawals don't happen all at once, the traditional IRA starts to earn less as soon as withdrawals start.

This is the same mistake I was making on the contribution end (comparing $2000 traditional contribution to $2000 Roth contribution) for a long time.

I haven't run the numbers (too complicated *whine*), but I'm sure it would be significant if you plan to be retired for more than a couple of years. Am I still missing something?

Ingrid
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Ingrid,

<<If I want $5000 of income from a traditional IRA, I have to take out $5000 + $1400, if I'm in the 28% bracket, vs. $5000 from the Roth IRA. So, if you take into account the fact that withdrawals don't happen all at once, the traditional IRA starts to earn less as soon as withdrawals start.>>

Just to be picky, if you want to net $5K after federal income tax, then from an all-deductible IRA you need to take more than $1,400 for taxes. Taxes will be applied on the total withdrawal, so the $5K you want to net is only 72% of what you need. That means you must take about $6, 944 (all of which will be taxed at 28%) to get the $5K you want.

That doesn't mean the IRA is "earning less," though. It only means you have to take more from the traditional IRA to match the same withdrawal you can take from a Roth. IF you assume both earn the same return before and after you start taking withdrawals; IF you assume you will be in the same tax bracket before and after withdrawals; and IF you make the same tax-equivalent contributions to either IRA (i.e., $2K to the traditional and $1,440 to the Roth), then over the long run they are exactly equal and both will be depleted at the same time (ignoring niceties like possible death and mandatory required distributions from the traditional IRA starting at age 70 ½, a subject far too complicated to get into for this simple comparison).

OTOH, IF all of the above is the same EXCEPT you make a full $2K contribution to the Roth, then the Roth will win.

Regards…..Pixy


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Pixy,

thanks for the info. seeing the numbers for the tax equivalent contributions were very insightful. the fact that both the front and back-loaded cases were exactly equal was not quite intuitive to me. somehow i felt that the number of years, the rate of return, and the distribution rate all had an affect on the outcome. so i guess the only real question is how good are you at predicting the future tax changes????? hmmmmm........ consumption tax and a lower income tax.........

in search of foolishness,
xtraFool
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XtraFool,

<< so i guess the only real question is how good are you at predicting the future tax changes????? hmmmmm........ consumption tax and a lower income tax......... >>

LOL. Probably about as good at that as I am in guessing Mrs. Pixy's shoe size. <g>

Regards….Pixy

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<< That doesn't mean the IRA is "earning less," though. It only means you have to take more from the
traditional IRA to match the same withdrawal you can take from a Roth. >>

Yes. I said it wrong. You are right about the amount needed to cover taxes also. I didn't think out my response enough.

<< IF you assume both earn the same return before and after you start taking withdrawals; IF you assume you will be in the same tax bracket before and after withdrawals; and IF you make the same tax-equivalent contributions to either IRA (i.e., $2K to the traditional and $1,440 to the Roth), then over the long run they are exactly equal and both will be depleted at the same time (ignoring niceties like possible death and mandatory required distributions from the traditional IRA starting at age 70 ½, a subject far too complicated to get into for this simple comparison). >>

Well, I don't think you need to make that many assumptions, but I do think you're right. I tried some examples starting with retirement (no more contributions, and $5000 income/year) from each. The results suprised me, and I'm still not convinced I didn't make a mistake since it's not intuitive to me. The results were that to get the same income you need 28% extra (or whatever the retirement tax bracket is) in the traditional IRA, regardless of growth after retirement or amount of income, or length of time you want the income to last. So, it seems that a lump sum distribution is _identical_ to long term income for Roth/traditional IRA contributions.

I finally decided that since you start with more in the Roth IRA (to be equivalent that is), you'll get more $ growth for the same % growth there -- obvious I guess, but I wasn't thinking about it right. So, that effect cancels out the fact that you take more of the principal (is that the right word for the contents of the IRA?) with every withdrawal. But it still doesn't seem like it should match exactly, no matter what the % growth rate. I'm confused! (But I know what I want to do with my money, so you don't have to try to enlighten me -- I may just be a little too dense for this one :)

Ingrid
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Ingrid,

<<I finally decided that since you start with more in the Roth IRA (to be equivalent that is), you'll get more $ growth for the same % growth there -- obvious I guess, but I wasn't thinking about it right. So, that effect cancels out the fact that you take more of the principal (is that the right word for the contents of the IRA?) with every withdrawal. But it still doesn't seem like it should match exactly, no matter what the % growth rate. I'm confused! (But I know what I want to do with my money, so you don't have to try to enlighten me -- I may just be a little too dense for this one :) >>

With the traditional deductible IRA, you pay the tax later. With the Roth, you pay the tax today. Therefore, if all else is equal, the results have to be the same over the long run.

Regards….Pixy
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Looking for answers!! I have read a lot of data but still confused as to the better road to travel. Have a
100K in a traditional IRA. I am 59 and expect to work
another 5years. Currently in 15% tax bracket and will in all likely hood remain there( unless one of you kind souls out there can endow me).Two part question,
going forward should my 2k contribution be Roth or traditional and should I convert the existing IRA over
to a Roth? I will need to use 15k of the IRA to make the converstion but there would not be an early withdrawal penalty. Hope some fool can help. thanks
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Greetings, ph00lish, and welcome. You wrote:

<<Looking for answers!! I have read a lot of data but still confused as to the better road to travel. Have a 100K in a traditional IRA. I am 59 and expect to work
another 5years. Currently in 15% tax bracket and will in all likely hood remain there (unless one of you kind souls out there can endow me).Two part question, going forward should my 2k contribution be Roth or traditional and should I convert the existing IRA over to a Roth? I will need to use 15k of the IRA to make the converstion but there would not be an early withdrawal penalty. >>


If your annual contribution choice is between a nondeductible traditional IRA and a nondeductible Roth IRA, then the Roth wins hands down because of the ultimate tax-free withdrawals. OTOH, if you are choosing between a fully-deductible traditional IRA and a Roth and you are using the same investment in each, the choice depends in general on what you think will happen to income taxes. If you think you'll be in the same marginal bracket in retirement as you are in now, then the net result is essentially the same for both. If you think your tax bracket will be higher in retirement, then the Roth is better. If you think your tax bracket will be lower, then the traditional IRA wins.

As to the conversion issue, generally if you must use IRA money to pay the taxes due on that conversion, then you're better off in the traditional IRA.

Use of a Roth IRA depends on a number of circumstances. I've outlined the major ones in an analysis posted on this board that you may read at http://boards.fool.com/Registered/Message.asp?id=1040013000441002&sort=postdate . Look it over. I think you will find it helpful.

Regards….Pixy
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ph00lish asked:

<<< Looking for answers!! I have read a lot of data but still confused as to the better road to travel. Have a 100K in a traditional IRA. I am 59 and expect to work another 5years. Currently in 15% tax bracket and will in all likely hood remain there( unless one of you kind souls out there can endow me).Two part question, going forward should my 2k contribution be Roth or traditional and should I convert the existing IRA over to a Roth? I will need to use 15k of the IRA to make the converstion but there would not be an early withdrawal penalty. Hope some fool can help. thanks >>>

TMFPixy gave his usual excellent response. I would add a few things to this however. First, if you converted the entire IRA in one year, you would no longer be in the 15% tax bracket for that year, and would probably need significantly more than $15K to pay the taxes. It doesn't make sense to let the conversion put you in a higher tax bracket than you expect to be upon withdrawal of the IRA. You do not need to convert the entire amount however. If you do convert, the best way to go would be to determine the maximum amount you could add to your current income each year and still stay in the 15% marginal tax bracket, and convert only that amount each year.
As to future contributions, as Pixy pointed out, taxwise it's essentially a wash if you remain in the same tax bracket. I would still go with the Roth, however. First off, I feel that for most people you get more 'bang for the buck' with the Roth. The statement above about it being a wash is only true if you invest the tax savings you get for having a deductable IRA in an investment equivalent to the IRA. I feel strongly that the majority of people fail to do this, causing the Trad. IRA to lose out to the Roth in the long run. Second, the Roth has some excellent features beyond the tax free accumulation of earnings. It does not have the same age limits as the traditional IRA wrt how old you can be and still contribute, or when you must begin manditory withdrawal from your IRA. The Roth is in general much more flexible. I therefore would tend to recommend a Roth over a traditional IRA for all future contributions, for someone in your situation.

Wavelength
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Dear Kilmarnoch,

I read a number of your Roth IRA and regular IRA comparison charts and commentary. I do find them both enlightening and confusing.

Do you have any current thoughts or reflections on the matter since the time you posted these messages?

I'm thinking that conversion would just place me in a higher bracket that would defeat the benefits of a Roth IRA. Partial conversions over a few years may work out better for most people.

Any comments are welcome. Janzy
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