Author Topic: Roth IRA vs taxable account  (Read 1444 times)

M5

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Roth IRA vs taxable account
« on: December 30, 2018, 01:03:55 PM »
Our current financial/investment situation is listed below. We're not exactly sure what the benefits are to contributing to a Roth IRA over a taxable account when we'll definitely want access to the money prior to age 59 1/2.we currently have both type of accounts open already but want to be sure we're maximizing our little green army.  We are turning 26 and 25 early next year, married filing jointly.

*I'm military so BAH and BAS aren't taxable income

Total gross household income: $112k
Gross after traditional TSP/401k contributions: $74k
Taxable gross income: $45k

We also have $7800/yr from a rental but that still keeps us in the 12% tax bracket.

Our guess is that the gains from contributing to a single taxable account will be better than splitting them into our separate Roth's. Plus the flexibility to withdraw at any time. Any advice is appreciated!


TomTX

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Re: Roth IRA vs taxable account
« Reply #1 on: December 30, 2018, 01:19:54 PM »
Our current financial/investment situation is listed below. We're not exactly sure what the benefits are to contributing to a Roth IRA over a taxable account when we'll definitely want access to the money prior to age 59 1/2.we currently have both type of accounts open already but want to be sure we're maximizing our little green army.  We are turning 26 and 25 early next year, married filing jointly.

*I'm military so BAH and BAS aren't taxable income

Total gross household income: $112k
Gross after traditional TSP/401k contributions: $74k
Taxable gross income: $45k

We also have $7800/yr from a rental but that still keeps us in the 12% tax bracket.

Our guess is that the gains from contributing to a single taxable account will be better than splitting them into our separate Roth's. Plus the flexibility to withdraw at any time. Any advice is appreciated!

Roth allows withdrawal of the contributions at any time with no penalty. Plus, the growth is 100% tax free.

COEE

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Re: Roth IRA vs taxable account
« Reply #2 on: December 30, 2018, 01:29:29 PM »
Between the two, I'd put it in a Roth IRA.  You can distribute contributions tax free at any time if you really need them.

Also read up on investment order if you haven't already:
https://forum.mrmoneymustache.com/investor-alley/investment-order/msg1333153/#msg1333153
https://www.bogleheads.org/wiki/Prioritizing_investments

35andFI

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Re: Roth IRA vs taxable account
« Reply #3 on: December 30, 2018, 01:38:04 PM »
Our guess is that the gains from contributing to a single taxable account will be better than splitting them into our separate Roth's.

Having say $1,000 in two serperate accounts will return the same amount as having $2,000 in one account assuming they are the same funds in the same type of account.

You will be better off maxing out tax advantages accounts before putting anything into taxable.

As mentioned above, you can withdraw contributions (not gains) in a Roth IRA at any time for any reason without penalty.

M5

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Re: Roth IRA vs taxable account
« Reply #4 on: December 30, 2018, 02:35:16 PM »
Our current financial/investment situation is listed below. We're not exactly sure what the benefits are to contributing to a Roth IRA over a taxable account when we'll definitely want access to the money prior to age 59 1/2.we currently have both type of accounts open already but want to be sure we're maximizing our little green army.  We are turning 26 and 25 early next year, married filing jointly.

*I'm military so BAH and BAS aren't taxable income

Total gross household income: $112k
Gross after traditional TSP/401k contributions: $74k
Taxable gross income: $45k

We also have $7800/yr from a rental but that still keeps us in the 12% tax bracket.

Our guess is that the gains from contributing to a single taxable account will be better than splitting them into our separate Roth's. Plus the flexibility to withdraw at any time. Any advice is appreciated!

Roth allows withdrawal of the contributions at any time with no penalty. Plus, the growth is 100% tax free.

True. Our plan would be to withdraw enough around age 45 (our target RE date) to either build or payoff our dream home. This would most likely exceed our $228k of estimated contributions by that point. Some quick math seems to support that even taking the 10% penalty on the gains outweighs paying taxes on dividends from a taxable account between now and then. Is this correct?

TomTX

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Re: Roth IRA vs taxable account
« Reply #5 on: December 30, 2018, 02:41:19 PM »
Our current financial/investment situation is listed below. We're not exactly sure what the benefits are to contributing to a Roth IRA over a taxable account when we'll definitely want access to the money prior to age 59 1/2.we currently have both type of accounts open already but want to be sure we're maximizing our little green army.  We are turning 26 and 25 early next year, married filing jointly.

*I'm military so BAH and BAS aren't taxable income

Total gross household income: $112k
Gross after traditional TSP/401k contributions: $74k
Taxable gross income: $45k

We also have $7800/yr from a rental but that still keeps us in the 12% tax bracket.

Our guess is that the gains from contributing to a single taxable account will be better than splitting them into our separate Roth's. Plus the flexibility to withdraw at any time. Any advice is appreciated!

Roth allows withdrawal of the contributions at any time with no penalty. Plus, the growth is 100% tax free.

True. Our plan would be to withdraw enough around age 45 (our target RE date) to either build or payoff our dream home. This would most likely exceed our $228k of estimated contributions by that point. Some quick math seems to support that even taking the 10% penalty on the gains outweighs paying taxes on dividends from a taxable account between now and then. Is this correct?

Or do both. Max out Roth, put more in taxable as well.

COEE

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Re: Roth IRA vs taxable account
« Reply #6 on: December 30, 2018, 06:19:05 PM »
Our current financial/investment situation is listed below. We're not exactly sure what the benefits are to contributing to a Roth IRA over a taxable account when we'll definitely want access to the money prior to age 59 1/2.we currently have both type of accounts open already but want to be sure we're maximizing our little green army.  We are turning 26 and 25 early next year, married filing jointly.

*I'm military so BAH and BAS aren't taxable income

Total gross household income: $112k
Gross after traditional TSP/401k contributions: $74k
Taxable gross income: $45k

We also have $7800/yr from a rental but that still keeps us in the 12% tax bracket.

Our guess is that the gains from contributing to a single taxable account will be better than splitting them into our separate Roth's. Plus the flexibility to withdraw at any time. Any advice is appreciated!

Roth allows withdrawal of the contributions at any time with no penalty. Plus, the growth is 100% tax free.

True. Our plan would be to withdraw enough around age 45 (our target RE date) to either build or payoff our dream home. This would most likely exceed our $228k of estimated contributions by that point. Some quick math seems to support that even taking the 10% penalty on the gains outweighs paying taxes on dividends from a taxable account between now and then. Is this correct?

I don't think your math is correct.  My understanding of roth-IRAs is that if you take a non-qualified distribution, you owe the 10% penalty PLUS you owe taxes on the gains at your marginal tax rate.  You could do a "substantially equal periodic payments" and avoid the tax, but then you couldn't withdrawal all the money at one time.

Attached is a file I put together with the numbers I came up with - it assumes the 12% tax bracket throughout.  Numbers end up being about the same.
« Last Edit: December 30, 2018, 06:20:57 PM by COEE »

M5

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Re: Roth IRA vs taxable account
« Reply #7 on: December 30, 2018, 08:00:49 PM »
Our current financial/investment situation is listed below. We're not exactly sure what the benefits are to contributing to a Roth IRA over a taxable account when we'll definitely want access to the money prior to age 59 1/2.we currently have both type of accounts open already but want to be sure we're maximizing our little green army.  We are turning 26 and 25 early next year, married filing jointly.

*I'm military so BAH and BAS aren't taxable income

Total gross household income: $112k
Gross after traditional TSP/401k contributions: $74k
Taxable gross income: $45k

We also have $7800/yr from a rental but that still keeps us in the 12% tax bracket.

Our guess is that the gains from contributing to a single taxable account will be better than splitting them into our separate Roth's. Plus the flexibility to withdraw at any time. Any advice is appreciated!

Roth allows withdrawal of the contributions at any time with no penalty. Plus, the growth is 100% tax free.

True. Our plan would be to withdraw enough around age 45 (our target RE date) to either build or payoff our dream home. This would most likely exceed our $228k of estimated contributions by that point. Some quick math seems to support that even taking the 10% penalty on the gains outweighs paying taxes on dividends from a taxable account between now and then. Is this correct?

I don't think your math is correct.  My understanding of roth-IRAs is that if you take a non-qualified distribution, you owe the 10% penalty PLUS you owe taxes on the gains at your marginal tax rate.  You could do a "substantially equal periodic payments" and avoid the tax, but then you couldn't withdrawal all the money at one time.

Attached is a file I put together with the numbers I came up with - it assumes the 12% tax bracket throughout.  Numbers end up being about the same.

Thanks for putting the spreadsheet together! I had been too lazy today to get that far. Seems like it's more personal preference at this point, with maybe a slight edge to taxable.

MDM

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Re: Roth IRA vs taxable account
« Reply #8 on: December 30, 2018, 11:02:39 PM »
One might make a defensible case for you to contribute much less to the traditional 401k/TSP and use the Roth versions of those instead.

Have you estimated your marginal tax rate in retirement using different traditional/Roth contributions between now and then?

COEE

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Re: Roth IRA vs taxable account
« Reply #9 on: December 31, 2018, 07:28:23 AM »
Thanks for putting the spreadsheet together! I had been too lazy today to get that far. Seems like it's more personal preference at this point, with maybe a slight edge to taxable.

You are welcome.  I wouldn't just toss a coin in the air and decide.  Look at the bigger picture, then decide.

Understand that Roth is intended for a retirement savings vehicle.  It has incredibly good advantages of not having to pay taxes on withdrawal.  This is especially helpful if you think you will be in a higher tax bracket in retirement.  With yourself in a 12% bracket, I don't see how you could not be in the same or higher tax bracket in the future.  If you use Roth space for what it's intended then you will likely save a LOT of money in the future.

If your main savings goal is really to buy a house outright after 20 years I would put the money in taxable.  Have you considered other options?  What about just buying a house with a 15 year mortgage?  How does that change your needed investment income for FIRE?  Would you then be able to use the Roth with "Substantially Equal Periodic Payments" (SEPP) rule to withdraw payments from your Roth so you don't have to pay the 10% penalty?  Can you save enough in taxable and in Roth as to max out the Roth for retirement, but also have a healthy down-payment for your house in taxable?

Pulling out a lump sum of that magnitude will probably put you into a higher marginal tax rate as well.  It will probably better to take the money out in smaller chunks to limit your taxable income as well.

My advice, I guess is to look at the bigger picture of what the savings vehicles purposes are and how to best use them to your advantage.

PS.  Current tax law also allows up to $10k of rIRA gains for use in a downpayment on your first home tax free.

wbarnett

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Re: Roth IRA vs taxable account
« Reply #10 on: January 02, 2019, 08:43:59 AM »
Have you considered the backdoor Roth IRA conversion strategy? Lots of people here employ this strategy; I'm planning to do the same in 2030.

You can convert TSP or 401k funds to a Roth IRA, and pay the appropriate income tax based on your bracket. There are laddering strategies to lessen the impact (i.e., do it little by little over several years instead of lump sum). The upside is that you end up with much more 'contributions' to your Roth IRA than the limit of $5,500 per year. Then you can access those contributions penalty free before 59.5, if needed.

35andFI

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Re: Roth IRA vs taxable account
« Reply #11 on: January 02, 2019, 09:21:54 AM »
Have you considered the backdoor Roth IRA conversion strategy? Lots of people here employ this strategy; I'm planning to do the same in 2030.

You can convert TSP or 401k funds to a Roth IRA, and pay the appropriate income tax based on your bracket. There are laddering strategies to lessen the impact (i.e., do it little by little over several years instead of lump sum). The upside is that you end up with much more 'contributions' to your Roth IRA than the limit of $5,500 per year. Then you can access those contributions penalty free before 59.5, if needed.

Just to be clear, what you are describing here is the Mega Backdoor Roth. The Backdoor (not mega) Roth is when someone who makes too much money to contribute directly to a Roth IRA contributes to a traditional IRA then rolls those funds into a Roth IRA.

The Mega Backdoor Roth is not something worth considering until other avenues (such as 401k,HSA,IRA) are maxed.
See here for investment order: https://forum.mrmoneymustache.com/investor-alley/investment-order/
« Last Edit: January 02, 2019, 09:24:48 AM by 35andFI »

walkwalkwalk

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Re: Roth IRA vs taxable account
« Reply #12 on: January 02, 2019, 09:25:34 AM »
Have you considered the backdoor Roth IRA conversion strategy? Lots of people here employ this strategy; I'm planning to do the same in 2030.

You can convert TSP or 401k funds to a Roth IRA, and pay the appropriate income tax based on your bracket. There are laddering strategies to lessen the impact (i.e., do it little by little over several years instead of lump sum). The upside is that you end up with much more 'contributions' to your Roth IRA than the limit of $5,500 per year. Then you can access those contributions penalty free before 59.5, if needed.

Just to be clear, what you are describing here is the Mega Backdoor Roth. The Backdoor Roth is when someone who makes too much money to contribute directly to a Roth IRA contributes to a traditional IRA then rolls those funds into a Roth IRA.

The Mega Backdoor Roth is not something worth considering until other avenues (such as 401k,HSA,IRA) are maxed.
See here for investment order: https://forum.mrmoneymustache.com/investor-alley/investment-order/
No, he had it right, its a roth conversion. Mega backdoor roth is when 401k has after-tax contributions and then you roll them over to roth, paying tax on the earnings.

35andFI

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Re: Roth IRA vs taxable account
« Reply #13 on: January 02, 2019, 09:37:06 AM »
No, he had it right, its a roth conversion. Mega backdoor roth is when 401k has after-tax contributions and then you roll them over to roth, paying tax on the earnings.

Right, I thought that's what was meant by "401k funds". If not then I stand corrected.

But that leads to the question of "why bother" unless the O.P. wanted to contribute more than the max IRA limits.
We can assume that their income is low enough to contribute directly to a Roth IRA since they are asking if they should.

rational_dblthinker

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wbarnett

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Re: Roth IRA vs taxable account
« Reply #15 on: January 06, 2019, 04:42:13 PM »
Quote

Right, I thought that's what was meant by "401k funds". If not then I stand corrected.

But that leads to the question of "why bother" unless the O.P. wanted to contribute more than the max IRA limits.
We can assume that their income is low enough to contribute directly to a Roth IRA since they are asking if they should.

Yep, I meant 401k contributions. Sorry for the sloppy terminology.

As for 'why bother' -- the OP mentioned wanting to pay for a dream home after FIRE at age 45. A Roth IRA conversion makes sense here, since he/she seems to be maxing out pre-tax 401k contributions and will have a substantial nest egg by then. Even a Roth 401k doesn't allow you to access contributions early, right?

ILikeDividends

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Re: Roth IRA vs taxable account
« Reply #16 on: January 06, 2019, 06:38:08 PM »
Even a Roth 401k doesn't allow you to access contributions early, right?
Wrong (I think*).

Roth IRA Withdrawal Rules
https://www.rothira.com/roth-ira-withdrawal-rules

"If you are under 59, you may withdraw the exact amount of your Roth IRA contributions with no penalties."



* I'm assuming a Roth 401K vs a Roth IRA are substantially the same except for higher contribution limits for the Roth 401K, but I haven't researched the specific question w.r.t. a Roth 401K in any depth because the OP referred to Roth IRA accounts.
« Last Edit: January 06, 2019, 06:54:24 PM by ILikeDividends »

35andFI

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Re: Roth IRA vs taxable account
« Reply #17 on: January 06, 2019, 06:51:52 PM »

Yep, I meant 401k contributions. Sorry for the sloppy terminology.

As for 'why bother' -- the OP mentioned wanting to pay for a dream home after FIRE at age 45. A Roth IRA conversion makes sense here, since he/she seems to be maxing out pre-tax 401k contributions and will have a substantial nest egg by then. Even a Roth 401k doesn't allow you to access contributions early, right?

It depends on how much they were looking to contribute, right?
If it’s no more than $6,000/yr (the max IRA contribution for 2019) then why would they bother contributing indirectly?
Since they were asking about contributing to a Roth IRA or a taxable account, I figured they didn’t have more than $6k to invest.
As far as accessing funds from a Roth 401K, I believe that you’re right (that is without rolling it over to a Roth IRA).
https://www.google.com/amp/s/ttlc.intuit.com/questions/4135547-roth-401k-withdrawal-penalties-taxes/amp
« Last Edit: January 06, 2019, 06:54:05 PM by 35andFI »

wbarnett

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Re: Roth IRA vs taxable account
« Reply #18 on: January 06, 2019, 09:28:14 PM »
Wrong (I think*).

Roth IRA Withdrawal Rules
https://www.rothira.com/roth-ira-withdrawal-rules

"If you are under 59, you may withdraw the exact amount of your Roth IRA contributions with no penalties."



* I'm assuming a Roth 401K vs a Roth IRA are substantially the same except for higher contribution limits for the Roth 401K, but I haven't researched the specific question w.r.t. a Roth 401K in any depth because the OP referred to Roth IRA accounts.

Roth IRAs are different than Roth 401ks in that regard. You can't access your contributions at any time in a Roth 401k, which is why Roth IRA conversion pipelines are so popular. It is possible to apply for a Roth 401k loan or hardship withdrawal, but that's complicated.

M5

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Re: Roth IRA vs taxable account
« Reply #19 on: January 14, 2019, 01:10:40 PM »
To answer a few questions..

My guess is our income in retirement would still be within the 12% federal tax bracket. I can't imagine us having 78k plus in income at retirement. We would most likely tall small withdrawals from retirement accounts to keep us below the 22% threshhold.

We would want to contribute at least 12k/yr (6k each) to either a Roth IRA or taxable. Maybe more, maybe less depending on how frugal we decide to be.

Our understanding (wife is also an accountant) is that the only difference in the Roth IRA vs taxable is the taxable funds are taxed on short term gains each year instead of only being taxed on the gains from a Roth IRA when you withdraw them. If this is indeed true, the difference with the early withdrawal penalty factored in should be negligible.

Am I off base with this?

EvenSteven

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Re: Roth IRA vs taxable account
« Reply #20 on: January 14, 2019, 01:31:05 PM »
Quote
Our understanding (wife is also an accountant) is that the only difference in the Roth IRA vs taxable is the taxable funds are taxed on short term gains each year instead of only being taxed on the gains from a Roth IRA when you withdraw them. If this is indeed true, the difference with the early withdrawal penalty factored in should be negligible.

Am I off base with this?

This is off base.

Each year a fund in a regular taxable account is taxed on dividends, short term capital gains distributed by the fund, and long term capital gains distributed by the fund. When you sell shares of the fund, you are then taxed on the capital gains (which may be taxed at 0% depending on your tax bracket).

In a Roth IRA, you don't pay any of those taxes, ever.

M5

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Re: Roth IRA vs taxable account
« Reply #21 on: January 14, 2019, 02:06:12 PM »
Quote
Our understanding (wife is also an accountant) is that the only difference in the Roth IRA vs taxable is the taxable funds are taxed on short term gains each year instead of only being taxed on the gains from a Roth IRA when you withdraw them. If this is indeed true, the difference with the early withdrawal penalty factored in should be negligible.

Am I off base with this?

This is off base.

Each year a fund in a regular taxable account is taxed on dividends, short term capital gains distributed by the fund, and long term capital gains distributed by the fund. When you sell shares of the fund, you are then taxed on the capital gains (which may be taxed at 0% depending on your tax bracket).

In a Roth IRA, you don't pay any of those taxes, ever.

Ah, I had the feeling I was missing something but the info on the internet is incredibly difficult to decipher on this subject. Any advice on how to incorporate that into spreadsheet calculations to do a factual comparison between the two for VTSAX?

MDM

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Re: Roth IRA vs taxable account
« Reply #22 on: January 14, 2019, 02:19:39 PM »
Ah, I had the feeling I was missing something but the info on the internet is incredibly difficult to decipher on this subject. Any advice on how to incorporate that into spreadsheet calculations to do a factual comparison between the two for VTSAX?
Table below is from the 'Misc. calcs' tab of the case study spreadsheet.

With no taxes (i.e., how a Roth works), the result would be $46,610 instead of $40,103.

Growth in a taxable account
cgt = capital gain tax rate, %15.0%
d = annual dividend rate, %2.0%
g = annual growth excluding dividends, %6.0%
n = years invested, yr20
Compounding periods/yr1
P = principal invested at start, $$10,000
Pmt = Recurring deposits, $$
1 = pmt at start, 0 = at end0
t = tax rate on dividends, %15.0%
nc = Number of compounding periods20
dc = compounding dividend rate, %2.0%
gc = compounding growth excl. div., %6.0%
e = tax-adjusted growth, %7.70%
ecgt = tax-adjusted cap. gain tax rate, %11.688%
Basis$17,526
FBT = Future, before tax, value$44,087
FAT = Future, after tax, value $40,103

M5

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Re: Roth IRA vs taxable account
« Reply #23 on: January 14, 2019, 03:34:57 PM »
Ah, I had the feeling I was missing something but the info on the internet is incredibly difficult to decipher on this subject. Any advice on how to incorporate that into spreadsheet calculations to do a factual comparison between the two for VTSAX?
Table below is from the 'Misc. calcs' tab of the case study spreadsheet.

With no taxes (i.e., how a Roth works), the result would be $46,610 instead of $40,103.

Growth in a taxable account
cgt = capital gain tax rate, %15.0%
d = annual dividend rate, %2.0%
g = annual growth excluding dividends, %6.0%
n = years invested, yr20
Compounding periods/yr1
P = principal invested at start, $$10,000
Pmt = Recurring deposits, $$
1 = pmt at start, 0 = at end0
t = tax rate on dividends, %15.0%
nc = Number of compounding periods20
dc = compounding dividend rate, %2.0%
gc = compounding growth excl. div., %6.0%
e = tax-adjusted growth, %7.70%
ecgt = tax-adjusted cap. gain tax rate, %11.688%
Basis$17,526
FBT = Future, before tax, value$44,087
FAT = Future, after tax, value $40,103

So what is the final value of the Roth after taxes on gains and early withdrawal penalty?

MDM

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Re: Roth IRA vs taxable account
« Reply #24 on: January 14, 2019, 03:58:04 PM »
So what is the final value of the Roth after taxes on gains and early withdrawal penalty?
What are you assuming for the amount of gains and your marginal tax rate?

robartsd

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Re: Roth IRA vs taxable account
« Reply #25 on: January 14, 2019, 04:36:24 PM »
True. Our plan would be to withdraw enough around age 45 (our target RE date) to either build or payoff our dream home. This would most likely exceed our $228k of estimated contributions by that point. Some quick math seems to support that even taking the 10% penalty on the gains outweighs paying taxes on dividends from a taxable account between now and then. Is this correct?
Use Roth contributions for the down payment, then rollover sufficient funds from taxable retirement account(s) into a traditional IRA to set up SEPP withdraws from that account to make the mortgage payments. Don't be so emotionally tied to being mortgage free that you take a sub-optimal route to FIRE.

M5

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Re: Roth IRA vs taxable account
« Reply #26 on: January 14, 2019, 04:53:29 PM »
So what is the final value of the Roth after taxes on gains and early withdrawal penalty?
What are you assuming for the amount of gains and your marginal tax rate?

Using the gains of one 10k contribution like you did for the above taxable calculation. marginal tax rate would be 12%

True. Our plan would be to withdraw enough around age 45 (our target RE date) to either build or payoff our dream home. This would most likely exceed our $228k of estimated contributions by that point. Some quick math seems to support that even taking the 10% penalty on the gains outweighs paying taxes on dividends from a taxable account between now and then. Is this correct?
Use Roth contributions for the down payment, then rollover sufficient funds from taxable retirement account(s) into a traditional IRA to set up SEPP withdraws from that account to make the mortgage payments. Don't be so emotionally tied to being mortgage free that you take a sub-optimal route to FIRE.

We would already be at FIRE by this point. So no worries about a sub-optimal route to get there.. We don't have the desire to have any debt after FIRE.

MDM

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Re: Roth IRA vs taxable account
« Reply #27 on: January 14, 2019, 05:20:11 PM »
So what is the final value of the Roth after taxes on gains and early withdrawal penalty?
What are you assuming for the amount of gains and your marginal tax rate?

Using the gains of one 10k contribution like you did for the above taxable calculation. marginal tax rate would be 12%
Tax = ($46,610 - $10000) * (12% + 10%) = $8,054.

Net = $46,610 - $8,054 = $38,556.