IRAs and retirement taxes

[Silly Moustache]

I've read this with interst - I'm in the UK and our arrangements are quite differnt and FAR simpler.

However, I'm not about to make comparisons, as I just wanted to say one thing to folks anxiously approaching retirement, because I think this is pretty universal .... I've known many people (including me - seven years ago) who panic when they realise that teir retirement income is somewhat less than their salary.

It is a stranfe fact but .... you most likely will find that your cost of living won't be as much as when you are working.

I base this on two main points of expenditure :
1. After retirement, no-one should have an outstanding mortgage - if you have, pay it off.

2. You don't have to save for retirement any more ! No more pension contributions or savings plans ... the race is over - you won!

Extra ... When a friend told me that it was far more expensive to work, than to retire I didn't believe him .. but it is true.

Yes prices increase over the years; food, gas, electricity, local taxes, etc., but - you don't "need" to have such a new car, because you'll drive a fraction of the miles you used to when commuting.
You don't need so many (or any) smart clothes, and you don't need to smoke/drink/whatever to ease the stress of working.

You also don't "need" vacations - unless you want to travel - every day is a Saturday!

[Bucc5207]

Originally Posted by MattM

So far the most informative reply was a PM where I was told that the IRS taxes 85% of your SS benefits.

It's anywhere from zero to 85%. It's probably not maxed out with the figures you presented. You have to do the worksheet.

But if you are tiptoeing toward the conclusion that paying tax now to buy a tax break later (the Roth proposal) is not necessarily a great plan, I won't try to talk you out of it!

[buddyhu]

Originally Posted by The Growler

So we agree. Your tax rates aren't going down.

We agree: you have to use a smiley face after such a statement.

[MattM]

Originally Posted by Bucc5207

It's anywhere from zero to 85%. It's probably not maxed out with the figures you presented. You have to do the worksheet.

But if you are tiptoeing toward the conclusion that paying tax now to buy a tax break later (the Roth proposal) is not necessarily a great plan, I won't try to talk you out of it!

Thanks. In hindsight, I did not select an example that illustrates my point very well due to the income I selected, where the tax bracket cutoffs line up, and etc.

Feel free to try to talk me out of it, or at least present some logic behind why the Roth is presented as a slam dunk for someone who is not going to be in a higher tax bracket when they retire, as the few retirees I talk to about it (older extended family, basically) are in a lower or the same bracket now than when they were working. In their case, at least so far, the Roth would have been a mistake.

[TBman]

Post deleted. HUMB

[Bucc5207]

Originally Posted by MattM

Thanks. In hindsight, I did not select an example that illustrates my point very well due to the income I selected, where the tax bracket cutoffs line up, and etc.

Feel free to try to talk me out of it, or at least present some logic behind why the Roth is presented as a slam dunk for someone who is not going to be in a higher tax bracket when they retire, as the few retirees I talk to about it (older extended family, basically) are in a lower or the same bracket now than when they were working. In their case, at least so far, the Roth would have been a mistake.

In your example, the Roth itself ironically created the bracket drop that made the Roth a bad choice. That's one of several reasons you have to run the numbers as realistically as possible for each specific case. Every taxpayer is different.

I'm not a big fan of Roth IRAs in general. They may or may not work as advertised (as you've shown), and I lean towards taking tax benefits now rather than later (bird in the hand theory). In order of decreasing desirability, I like: 401(k) (and similar) deferrals, deductible traditional IRAs, Roth IRAs, and nondeductible IRAs. As for converting existing IRAs to Roth, you need a darn good reason to do it, IMO (and some people do have a good reason).

[Bucc5207]

Originally Posted by TBman

Only the earnings on the ROTH ira are taxable when you begin distributions, I don't know how it works, in other words, how they determine how much of each to distribute. Just off the top of my head my guess would be that if you have a total of $300,000 in the ROTH IRA and $200,000 of it is principal when you reach retirement and begin RMD, then 2/3 of the distributions would be tax free, in its simplest form. But this is a moving target, the funds keep earning, but you get the idea.

That is incorrect. Qualified distributions from Roth IRAs are not taxed; not the principal (basis), and not the earnings. See http://www.irs.gov/pub/irs-pdf/p590b.pdf

[TBman]

Originally Posted by Bucc5207

That is incorrect. Qualified distributions from Roth IRAs are not taxed; not the principal (basis), and not the earnings. See http://www.irs.gov/pub/irs-pdf/p590b.pdf

Thanks. This is why I stick to general accounting.

[Bucc5207]

Originally Posted by TBman

Thanks. This is why I stick to general accounting.

You're welcome! And thank you, because you tripped the switch in my brain to tell me what was bugging me about this thread:

Originally Posted by MattM

If her were married, he would only be saving 15% on the distributions, as the break is almost $75,000 for married filing jointly. It would not be a good swap to pay 25% taxes on contributions now to save 15% on distributions later.

Here's what's missing: the above assumes the $25k Roth distribution was all from basis, that is, original contributions. Suppose the original contribution was only $5k, that had grown to $25k? Then the married taxpayer paid tax of $1250 (25% of $5000), but saved $3750 (15% of $25000) on the distribution.

That doesn't sound like such a bad deal. But was that luck, or good long-term planning?

[MattM]

Originally Posted by Bucc5207

You're welcome! And thank you, because you tripped the switch in my brain to tell me what was bugging me about this thread:


Here's what's missing: the above assumes the $25k Roth distribution was all from basis, that is, original contributions. Suppose the original contribution was only $5k, that had grown to $25k? Then the married taxpayer paid tax of $1250 (25% of $5000), but saved $3750 (15% of $25000) on the distribution.

It actually doesn't matter whether the $25K was from basis or earnings. The bottom line is that if your AGI places you in a lower bracket now than you will be in retirement, the Roth is the correct choice; otherwise, it is not.

Here's why: Lets take two people who both manage to save $1,000 per month for a year, and both are in the 25% tax bracket. One puts all $12,000 in a traditional IRA that earns 10% annually, and does that every year. The other pays his $3,000 in taxes and puts the remaining $9,000 into a Roth IRA in the exact same mutual funds and earns that exact same 10% annual return. After 10 years, person A has $204,845 and person B has $153,633 (i.e. person A has exactly 33% more).

Assuming they are both still in the 25% bracket when they retire, if they both need $30,000 per year from IRAs to pay living expenses, person B can just take $30K and be done, but person A has to take $40K and pay $10K in taxes to net $30K (again, exactly 33% more). So if the tax bracket remains the same, there is no advantage to either IRA over the other that I can see.

If you take these same numbers and run them with the tax bracket changing at retirement, you will see that it is better to use the Roth if you expect your bracket to go up, and better to use the traditional IRA/401K if you expect it to be lower.

Disclaimer: I am not an accountant of any type, just mathematically inclined.

[Bucc5207]

Originally Posted by MattM

It actually doesn't matter whether the $25K was from basis or earnings. The bottom line is that if your AGI places you in a lower bracket now than you will be in retirement, the Roth is the correct choice; otherwise, it is not.

Here's why: Lets take two people who both manage to save $1,000 per month for a year, and both are in the 25% tax bracket. One puts all $12,000 in a traditional IRA that earns 10% annually, and does that every year. The other pays his $3,000 in taxes and puts the remaining $9,000 into a Roth IRA in the exact same mutual funds and earns that exact same 10% annual return. After 10 years, person A has $204,845 and person B has $153,633 (i.e. person A has exactly 33% more).

Assuming they are both still in the 25% bracket when they retire, if they both need $30,000 per year from IRAs to pay living expenses, person B can just take $30K and be done, but person A has to take $40K and pay $10K in taxes to net $30K (again, exactly 33% more). So if the tax bracket remains the same, there is no advantage to either IRA over the other that I can see.

If you take these same numbers and run them with the tax bracket changing at retirement, you will see that it is better to use the Roth if you expect your bracket to go up, and better to use the traditional IRA/401K if you expect it to be lower.

Disclaimer: I am not an accountant of any type, just mathematically inclined.

Never mind statutory limits to contributions, I ran the numbers with your parameters and got the same results. Very interesting, thank you. Both taxpayers have the same spendable cash after taxes before and after retiring, and they both run out of money at about the same time. Taxpayer A pays more tax in retirement than he saved while working, so the Traditional IRA is a better deal for The Man in the long term even if it makes no real net difference to the taxpayer.

Of course, if tax rates increase before they retire, A has to draw more to net $30k and he drains his account faster. Or, if the government finds a way to renege on the Roth promise, B's plan is destroyed. I think I'll continue to favor the bird in the hand.

I'd also like to point out that because of contribution limits, phase-outs, and such, Traditional vs Roth IRA is kind of a retirement sideshow. Much larger amounts can be put toward retirement through 401(k) and similar plans, which often include nontaxable employer matching and/or profit sharing contributions. Participation in such a plan eliminates the option of deductible contributions to Traditional IRAs, pushing them farther to the planning sidelines. Most 401(k) plans now allow designating some contributions as Roth-like, so one can still enjoy Traditional vs Roth games within the 401(k) framework.

[buddyhu]

The value of a Roth is not straightforward. However, I'd like to add a few thoughts (which might be off base...I trust others will correct if so; I am already retired, already made my choices of retirement vehicles years ago, so I don't think of such things anymore and don't stay current in laws).

If either your state or federal governments raise income tax rates even a couple of percent between when you contribute and when you draw, that might be enough to make a Roth a more favorable option.

If income tax rates remain the same, but the effects of inflation push you into a higher tax bracket (seems hard to fathom, but find a compound interest calculator online and see what 2% interest compounded yearly over two or three decades can do), a Roth might be better.

If you happen to die before you exhaust you retirement monies, your beneficiaries might enjoy some tax savings if they are in a higher tax bracket than you are (and this also ties in to my second point about the effects of inflation).

When I last was considering retirement vehicles, I was a fan of 401K's, either single owner 401K's for the self-employed (you can contribute a LOT of money and get a big deduction), or employer sponsored plans (LOVED the employer match of contributions).

[MattM]

Originally Posted by Bucc5207

I'd also like to point out that because of contribution limits, phase-outs, and such, Traditional vs Roth IRA is kind of a retirement sideshow. Much larger amounts can be put toward retirement through 401(k) and similar plans, which often include nontaxable employer matching and/or profit sharing contributions. Participation in such a plan eliminates the option of deductible contributions to Traditional IRAs, pushing them farther to the planning sidelines. Most 401(k) plans now allow designating some contributions as Roth-like, so one can still enjoy Traditional vs Roth games within the 401(k) framework.

The main reason that I brought this up is that I am helping one of my pastors with his retirement choices in an account where he is able to choose between a traditional 401k option vs. a Roth 401k option. Pastors pay high taxes, but that is mostly due to paying both sides of social security (if they don't opt out, which they should!). I am working under the assumption that either option would not effect social security taxes due now.

My own situation is that I have a SEP IRA and a Roth, but am now employed by my own tiny LLC, so can no longer contribute to the SEP anymore.

I personally think the Roth will remain intact. I agree with Dave Ramsey that "the only way they take away the Roth promise is for our country to become totally communist and do away with the entire concept of personal property!"

[Bucc5207]

Originally Posted by MattM

I personally think the Roth will remain intact. I agree with Dave Ramsey that "the only way they take away the Roth promise is for our country to become totally communist and do away with the entire concept of personal property!"

We once thought Social Security benefits would never be taxed, since they were promoted as a return of our own money that we 'contributed' in a non-deductible, after-tax fashion. Just saying.