Author Topic: Roth vs. Reg. IRA tax question  (Read 1648 times)

DeniseNJ

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Roth vs. Reg. IRA tax question
« on: March 19, 2019, 01:33:02 PM »
I get that you would want to defer taxes if you think you may be in a lower tax bracket upon retirement or whenever you plan on taking the money.  Or you think you might move to a low or no tax state, then defering makes sense. But when you take your Roth money you already paid taxes on your investment and you don't owe taxes on the growth.  In a tax defered plan you end up paying taxes on the investment AND the growth.  Wouldn't that almost automatically make a Roth the better option?  Obviously there are roll over and other considerations but if your money doubled, you'd only pay tax on half of it rather than on all of it later. Or am I missing something big?

ender

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Re: Roth vs. Reg. IRA tax question
« Reply #1 on: March 19, 2019, 01:45:57 PM »
I get that you would want to defer taxes if you think you may be in a lower tax bracket upon retirement or whenever you plan on taking the money.  Or you think you might move to a low or no tax state, then defering makes sense. But when you take your Roth money you already paid taxes on your investment and you don't owe taxes on the growth.  In a tax defered plan you end up paying taxes on the investment AND the growth.  Wouldn't that almost automatically make a Roth the better option?  Obviously there are roll over and other considerations but if your money doubled, you'd only pay tax on half of it rather than on all of it later. Or am I missing something big?

If you make $100k and put $15k into a Roth 401k, your overall takehome pay ends up being lower than if you do a traditional 401k (same calculation for IRAs). This is because you are paying taxes on the Roth money and not the traditional money, which means your taxable income is $100k vs $85k.



Telecaster

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Re: Roth vs. Reg. IRA tax question
« Reply #2 on: March 19, 2019, 01:46:13 PM »
With a tIRA, you get a tax deduction now (exceptions noted), and pay the taxes at withdrawal.

With a Roth, you pay the taxes now, and pay no taxes at withdrawal.

If the tax brackets and dollar amounts are the same, mathematically it doesn't matter if you pay the taxes now or later.  It works out exactly the same. 

There is a wrinkle though, if you take the tax deduction now (tIRA) you have more money right now to invest.   So with the tIRA you could invest $5,500, plus however much you saved on your taxes (top marginal rate * $5,500).

sol

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Re: Roth vs. Reg. IRA tax question
« Reply #3 on: March 19, 2019, 01:57:03 PM »
You're missing several things.

The big one, in most cases, is the employer match on 401k.  You can get 100% growth on day one in a 401k plan that you cannot get in a Roth, if your employer offers a 1:1 match on some portion of your savings.

It's also important to distinguish between a 401k plan (or traditional IRA) and a taxable investment account.  Your 401k is just like a Roth IRA in that it does not pay taxes on growth each year, the way a taxable account does. 

Another is that the taxes you eventually pay on the 401k might still be zero, if you can pull them out in the 0% tax bracket.  When you choose to pay taxes on that money today, you pay at the top of your tax scale, the highest marginal rate on the last dollar earned and working backwards.  When you pay taxes in retirement, with no other income, you pay taxes at the bottom of your tax scale, starting at zero percent on the standard deduction and moving up from there.

From a tax perspective, the Roth IRA is rarely a better deal than a 401k plan, unless your 401k plan options are truly atrocious.  We all use them both, to maximize both kinds of tax incentives, but it's a rare case where you should put money into a Roth instead of a 401k.  One of those cases, though, is for new graduates or other low-income people who don't owe any federal income taxes anyway.  If you make less than $12k/yr as a single person or $24k/yr as MFJ, and don't get any employer match, then you should fill the Roth first because you would avoid taxes today and tomorrow and forever.


DeniseNJ

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Re: Roth vs. Reg. IRA tax question
« Reply #4 on: March 19, 2019, 01:57:19 PM »
I get the implications of paying now vs. paying later but for the sake of the math, let's say the tax rate is the same (we don't know what it might be in the futre anyway).  Yes you pay tax on the Roth investment now, but upon withdrawel you get both the investment money tax "free" (since you've already paid) but you also get the growth .  With the tIRA you pay upon withdrawel on BOTH the investment amount and on the growth.  Is that right?  In a Roth all of your growth is tax free--you don't pay taxes on it now, since it doesn't exist yet, or later.  Right?

DeniseNJ

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Re: Roth vs. Reg. IRA tax question
« Reply #5 on: March 19, 2019, 02:02:24 PM »
Quote
The big one, in most cases, is the employer match on 401k.  You can get 100% growth on day one in a 401k plan that you cannot get in a Roth, if your employer offers a 1:1 match on some portion of your savings.
Yes, the 401K is idfferent altogether, because of salary limits, matching contributions, mandatory withdrawels, Roth options within the 401K etc.  But bet. the Roth and traditional IRA, isn't it true that you get all of the earning tax free?  Or do you somehow have to pay taxes on the growth?

EvenSteven

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Re: Roth vs. Reg. IRA tax question
« Reply #6 on: March 19, 2019, 02:07:25 PM »
I think you've got the rules right. Example at a 20% tax rate:

$1,000 in traditional, earning 5% per year for 15 years = $1980, pay 20% taxes and your left with $1584

$800 in Roth, earning 5% per year for 15 years = $1584

ender

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Re: Roth vs. Reg. IRA tax question
« Reply #7 on: March 19, 2019, 02:11:02 PM »
I get the implications of paying now vs. paying later but for the sake of the math, let's say the tax rate is the same (we don't know what it might be in the futre anyway).  Yes you pay tax on the Roth investment now, but upon withdrawel you get both the investment money tax "free" (since you've already paid) but you also get the growth .  With the tIRA you pay upon withdrawel on BOTH the investment amount and on the growth.  Is that right?  In a Roth all of your growth is tax free--you don't pay taxes on it now, since it doesn't exist yet, or later.  Right?

The bolded is wrong - you pay taxes on all the money you put into a Roth IRA/401k immediately.

You do not pay that on the contributions to the traditional IRA/401k.

I think you've got the rules right. Example at a 20% tax rate:

$1,000 in traditional, earning 5% per year for 15 years = $1980, pay 20% taxes and your left with $1584

$800 in Roth, earning 5% per year for 15 years = $1584

This is why ^

DeniseNJ

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Re: Roth vs. Reg. IRA tax question
« Reply #8 on: March 19, 2019, 02:13:58 PM »
Quote
I think you've got the rules right. Example at a 20% tax rate:

$1,000 in traditional, earning 5% per year for 15 years = $1980, pay 20% taxes and your left with $1584

$800 in Roth, earning 5% per year for 15 years = $1584

Ah ha.  Thanks for for the tidy example.  So it's a wash and the choice has to be made on other factors for your current and anticipated circumstances.  Good to know.

Another thing funny thing thought is that most ppl don't say,"Should I put 1,000 in a traditional or 800 in a Roth/"  Usually they say, "I have 1,000 bucks--should I put it in the traditional or the Roth?" So I guess your own psychology has to factor in too.

DeniseNJ

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Re: Roth vs. Reg. IRA tax question
« Reply #9 on: March 19, 2019, 02:17:53 PM »
Quote from: DeniseNJ on Today at 01:57:19 PM
I get the implications of paying now vs. paying later but for the sake of the math, let's say the tax rate is the same (we don't know what it might be in the futre anyway).  Yes you pay tax on the Roth investment now, but upon withdrawel you get both the investment money tax "free" (since you've already paid) but you also get the growth .  With the tIRA you pay upon withdrawel on BOTH the investment amount and on the growth.  Is that right?  In a Roth all of your growth is tax free--you don't pay taxes on it now, since it doesn't exist yet, or later.  Right?
Quote
The bolded is wrong - you pay taxes on all the money you put into a Roth IRA/401k immediately.

You do not pay that on the contributions to the traditional IRA/401k.

Sorry that wasn't clear--you pay taxes on the contributions now, but the gains don't get taxed now or later.  But like the example given before, if you put less in the Roth to pay off your tax bill, then it would be a wash--unless taxes double and I end up losing all of my SALT deductions and credits!  But I digress.

DeniseNJ

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Re: Roth vs. Reg. IRA tax question
« Reply #10 on: March 19, 2019, 02:27:52 PM »
ooh, another good thing about Roth options in a 401K or TSP is the contirbution limit is still the same $19K--you kinda end up contributing more since the taxes come out of your pocket, not out of the contribution limit.  So it's not like an option of 19K in 401 or 15,200 in a Roth.  Just naother interesting aspect to consider.  Thanks you guys!

EvenSteven

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Re: Roth vs. Reg. IRA tax question
« Reply #11 on: March 19, 2019, 02:35:03 PM »
Quote
I think you've got the rules right. Example at a 20% tax rate:

$1,000 in traditional, earning 5% per year for 15 years = $1980, pay 20% taxes and your left with $1584

$800 in Roth, earning 5% per year for 15 years = $1584

Ah ha.  Thanks for for the tidy example.  So it's a wash and the choice has to be made on other factors for your current and anticipated circumstances.  Good to know.

Another thing funny thing thought is that most ppl don't say,"Should I put 1,000 in a traditional or 800 in a Roth/"  Usually they say, "I have 1,000 bucks--should I put it in the traditional or the Roth?" So I guess your own psychology has to factor in too.

Yeah, the considerations for deciding between the two (in no particular order):

1) Tax rate now vs. tax rate when you withdraw

2) Current rules for which account types you are allowed to contribute to

3) How much tax diversity do you want in order to hedge against unknown future tax rates

4) Do you have enough outside of tax-deferred for a 5 year bridge for a Roth IRA conversion ladder if you are wanting to get at that money before 60 years old

sol

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Re: Roth vs. Reg. IRA tax question
« Reply #12 on: March 19, 2019, 02:53:56 PM »
Very few people on an early retirement board are expecting to pay a higher tax rate in retirement than they are paying while working.  The whole process of getting to FIRE means you live on less than you earn, and presumably will continue to live on a similar amount in retirement.  Because that amount is smaller than your current earnings it should get a lower effective tax rate than your current earnings.

That's a gross simplification, of course.  Things like child tax credits or ACA subsidies or large charitable donations can override the difference.

phildonnia

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Re: Roth vs. Reg. IRA tax question
« Reply #13 on: March 19, 2019, 05:28:10 PM »
Quote
The big one, in most cases, is the employer match on 401k.  You can get 100% growth on day one in a 401k plan that you cannot get in a Roth, if your employer offers a 1:1 match on some portion of your savings.
Yes, the 401K is idfferent altogether, because of salary limits, matching contributions, mandatory withdrawels, Roth options within the 401K etc.  But bet. the Roth and traditional IRA, isn't it true that you get all of the earning tax free?  Or do you somehow have to pay taxes on the growth?

Consider a hypothetical example, where we put $19k into either a Roth or a Traditional.  Assume a flat tax rate of 15%, and a 30-year growth of 300%.

Roth:
Start with $19k.
Pay 15% tax: you now have $16,150
Earn 300% over 30 years.  You now have $48,450
Take your money out, tax free.  Final score: $48,450

Traditional:

Start with $19k.
Earn 300% over 30 years.  You now have $57,000.
Take it out and pay 15% tax.  You now have $48,450.

Did you spot the difference?  Here it is: with the Traditional option, you maxed out the contribution, but not with the Roth.  You only put $16,150 in a tax deferred account, although the limit was much higher.  You could have crammed even more money into the Roth to grow tax-advantaged.

Once again but this time start with $22k:

Roth:
Start with $22k.
Pay 15% tax: you now have $18,700
Earn 300% over 30 years.  You now have $56,100
Take your money out, tax free.  Final score: $56,100

Traditional:
Start with $22k.
Put $19,000 in the IRA, pay tax on $3k, and put $2550 in a taxable account. 
Earn 300% over 30 years.  You now have $57,000, in the IRA, and $7650 outside.
Take it all out and pay 15% tax, plus 15% on the gain in the taxable account.
You now have $48,450 from the IRA, and $6885 in the taxable account.
Total: $55,335






ender

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Re: Roth vs. Reg. IRA tax question
« Reply #14 on: March 20, 2019, 08:33:58 AM »
Yeah, the considerations for deciding between the two (in no particular order):

1) Tax rate now vs. tax rate when you withdraw

2) Current rules for which account types you are allowed to contribute to

3) How much tax diversity do you want in order to hedge against unknown future tax rates

4) Do you have enough outside of tax-deferred for a 5 year bridge for a Roth IRA conversion ladder if you are wanting to get at that money before 60 years old

Another consideration is how likely someone is to save otherwise (this applies less imo on this board than in general).

If I am talking to someone who is the "save X% and spend the rest" sort, I'm going to recommend Roth options, because it means they will save a higher effective amount than if they did traditional. It might be less tax efficient but if the option is "pay more taxes and blow less" then I'm going to suggest they do Roth.


EvenSteven

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Re: Roth vs. Reg. IRA tax question
« Reply #15 on: March 20, 2019, 08:50:10 AM »
ooh, another good thing about Roth options in a 401K or TSP is the contirbution limit is still the same $19K--you kinda end up contributing more since the taxes come out of your pocket, not out of the contribution limit.  So it's not like an option of 19K in 401 or 15,200 in a Roth.  Just naother interesting aspect to consider.  Thanks you guys!

Yeah, the considerations for deciding between the two (in no particular order):

1) Tax rate now vs. tax rate when you withdraw

2) Current rules for which account types you are allowed to contribute to

3) How much tax diversity do you want in order to hedge against unknown future tax rates

4) Do you have enough outside of tax-deferred for a 5 year bridge for a Roth IRA conversion ladder if you are wanting to get at that money before 60 years old

Another consideration is how likely someone is to save otherwise (this applies less imo on this board than in general).

If I am talking to someone who is the "save X% and spend the rest" sort, I'm going to recommend Roth options, because it means they will save a higher effective amount than if they did traditional. It might be less tax efficient but if the option is "pay more taxes and blow less" then I'm going to suggest they do Roth.

Both good points about investor psychology, to which none of us are immune. I see giant red flags whenever someone insists that no psychology or behavioral economics ever apply to them because they are a purely rational creature.

DeniseNJ

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Re: Roth vs. Reg. IRA tax question
« Reply #16 on: March 20, 2019, 02:05:41 PM »
Quote
Both good points about investor psychology, to which none of us are immune. I see giant red flags whenever someone insists that no psychology or behavioral economics ever apply to them because they are a purely rational creatur
e.

Defintitely--even the fact that it's easier to take money out of your Roth during "emergencies," real or imagined, can tank your Roth amount long term is a true consideration.

Quote
Once again but this time start with $22k:

Roth:
Start with $22k.
Pay 15% tax: you now have $18,700
Earn 300% over 30 years.  You now have $56,100
Take your money out, tax free.  Final score: $56,100

Traditional:
Start with $22k.
Put $19,000 in the IRA, pay tax on $3k, and put $2550 in a taxable account. 
Earn 300% over 30 years.  You now have $57,000, in the IRA, and $7650 outside.
Take it all out and pay 15% tax, plus 15% on the gain in the taxable account.
You now have $48,450 from the IRA, and $6885 in the taxable account.
Total: $55,335

Yes, this is where I started with my questioning.  It may not be an issue if you have exactly 10K to invest and pay taxes in total but if you're looking to max out, all other things being equal, You'd do better with the Roth just bc you'd be starting with more in the account.  You'd still do the tradtional if you're high income and need the tax breaks right now, but it's great to consider all the implications.

MDM

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Re: Roth vs. Reg. IRA tax question
« Reply #17 on: March 20, 2019, 06:58:45 PM »
Consider a hypothetical example, where we put $19k into either a Roth or a Traditional.
See Maxing out your retirement accounts for a way to estimate just how much lower the withdrawal tax rate needs to be for traditional to be better than Roth in this situation.

CorpRaider

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Re: Roth vs. Reg. IRA tax question
« Reply #18 on: March 22, 2019, 07:03:41 AM »
I kind of think Roths are usually suboptimal.  Can't forget about the exclusion of qualified dividends and LTCG if you can get your income down below the applicable thresholds (which is ~$100K for MFJ if I recall, when you factor in the new standard deduction).

Proud Foot

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Re: Roth vs. Reg. IRA tax question
« Reply #19 on: April 01, 2019, 02:02:47 PM »
If you are the typical ER/Mustachian then the traditional IRA will be the most optimal as long as you are eligible to deduct your contributions. The big thing to remember is that your Roth contributions are taxed at your current marginal rate whereas when you make withdrawals from the Traditional you start over in the lowest tax bracket. This typically will be 0%. This is where the biggest confusion comes in. Many people look at the marginal rate for the comparison rather than the effective rate on the withdrawals from the IRA. As long as you are not pulling out the full amount at retirement you typically will not have a higher effective rate upon withdrawal than the marginal rate at contribution. Look at the link MDM posted for a detailed example of this.

Consider a hypothetical example, where we put $19k into either a Roth or a Traditional.  Assume a flat tax rate of 15%, and a 30-year growth of 300%.

Why assume a flat rate? Always try to use the best information available and run the numbers on based upon the current tax program. This makes a big difference when you run the numbers, particularly when you start running scenarios with multiple years of contributions and a higher balance at retirement.


MDM

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Re: Roth vs. Reg. IRA tax question
« Reply #20 on: April 01, 2019, 02:13:29 PM »
If you are the typical ER/Mustachian then the traditional IRA will be the most optimal as long as you are eligible to deduct your contributions.
Yes.

Quote
The big thing to remember is that your Roth contributions are taxed at your current marginal rate whereas when you make withdrawals from the Traditional you start over in the lowest tax bracket. This typically will be 0%. This is where the biggest confusion comes in.
Unfortunately one cannot ignore "unavoidable" income such as pensions, SS benefits, and withdrawals based on previous traditional contributions.

Quote
Many people look at the marginal rate for the comparison rather than the effective rate on the withdrawals from the IRA.
And the people who compare marginal vs. marginal are doing it correctly.

Quote
As long as you are not pulling out the full amount at retirement you typically will not have a higher effective rate upon withdrawal than the marginal rate at contribution. Look at the link MDM posted for a detailed example of this.
Yes, do see that link which includes "The main reason to prefer one type of account over the other is the comparison of marginal tax rates."

Note that withdrawals from this and future years' contributions will come "on top of" withdrawals based on previous years' contributions.  That's why one needs to look at marginal instead of effective rates.

Proud Foot

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Re: Roth vs. Reg. IRA tax question
« Reply #21 on: April 01, 2019, 02:32:51 PM »
Thank you for pointing out where I was wrong MDM. I sincerely appreciate it. This is one area where I know there is more for me to learn.

MDM

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Re: Roth vs. Reg. IRA tax question
« Reply #22 on: April 01, 2019, 02:37:21 PM »
Thank you for pointing out where I was wrong MDM. I sincerely appreciate it. This is one area where I know there is more for me to learn.
Welcome to the club!

Once upon a time I saw the same "marginal vs. effective" claim and it seemed so reasonable....

Fortunately others pointed out the fallacy so I'm just paying it forward. :)