IRA Max?

[trammatic]

So, if you're contributing the max amount to an IRA per year, that's $5k, right?  And the big difference between a traditional and Roth is when you pay taxes on them...right?  But it seems like if you pick a Roth, you can effectively save more. 

Take a person in the 25% bracket.  In a traditional IRA, they end up paying 3850 out of pocket because of the deduction.  If they were to use a Roth, they'd pay 5000 out of pocket with no deduction.  Put another way, savings + taxes is 5000 for the traditional and 6250 for the Roth.  So in either way, it seems like you can save more with a Roth because the taxes are not part of the cap.

Am I completely off my rocker?  If not, I'm amazed that no one ever mentions this when talking about "maxing it out".

[sol]

So, if you're contributing the max amount to an IRA per year, that's $5k, right?

The $5k limit applies to the Roth IRA and the traditional IRA.  The limits are higher for Simple IRAs and SEP IRAs.  The limits go up to $6k/yr for people over 50 years old, and are subject to income limits which preclude people who make too much money.  Virtually everyone with an employer is also eligible for something like a 401k plan, with a $17k/yr limit (pretax).

And the big difference between a traditional and Roth is when you pay taxes on them...right?  But it seems like if you pick a Roth, you can effectively save more. 

Yes, the timing of the taxes is the key difference.  The apparent higher limit on the Roth option is something of an illusion, though, if you are like most people on this site and saving a majority of your income.  Because such people are saving most of their income now, while working, they will retire in a much lower tax bracket and thus pay much lower taxes.  Since the Roth requires that you pay taxes now, while you are in the highest tax bracket of your life, its benefits are somewhat dulled.

Am I completely off my rocker?  If not, I'm amazed that no one ever mentions this when talking about "maxing it out".

I think that when most people here talk about "maxing it out" they mean contributing the full 17k/year to their 401k and 5k/year to their Roth IRA.  That's $22k/year, plus whatever employer match they can get, in a combination of tax-deferred and tax-free accounts.

[fiveoh]

So, if you're contributing the max amount to an IRA per year, that's $5k, right?

The $5k limit applies to the Roth IRA and the traditional IRA.  The limits are higher for Simple IRAs and SEP IRAs.  The limits go up to $6k/yr for people over 50 years old, and are subject to income limits which preclude people who make too much money.  Virtually everyone with an employer is also eligible for something like a 401k plan, with a $17k/yr limit (pretax).

And the big difference between a traditional and Roth is when you pay taxes on them...right?  But it seems like if you pick a Roth, you can effectively save more. 

Yes, the timing of the taxes is the key difference.  The apparent higher limit on the Roth option is something of an illusion, though, if you are like most people on this site and saving a majority of your income.  Because such people are saving most of their income now, while working, they will retire in a much lower tax bracket and thus pay much lower taxes.  Since the Roth requires that you pay taxes now, while you are in the highest tax bracket of your life, its benefits are somewhat dulled.

Am I completely off my rocker?  If not, I'm amazed that no one ever mentions this when talking about "maxing it out".

I think that when most people here talk about "maxing it out" they mean contributing the full 17k/year to their 401k and 5k/year to their Roth IRA.  That's $22k/year, plus whatever employer match they can get, in a combination of tax-deferred and tax-free accounts.

Depending on how long it is till you retire, you could still be pa ying more taxes then you do now even with a lower income.   Hard to say what taxes will look like 15,10 or even 5 years from now.   Although they could change the way the Roth works as well... it's a little of a gamble imo vs the traditional being a "sure thing" since you know what you will be saving up front.   Even so, both my wife and my IRA accounts are Roth.   

[shedinator]

ard to say what taxes will look like 15,10 or even 5 years from now.   Although they could change the way the Roth works as well...

No, they really couldn't... Technically, the law could be changed, but I think anyone writing tax code knows that double-taxing Roth contributors would be political suicide. They could discontinue the Roth option, but it is HIGHLY unlikely that existing Roth contributions would not be grandfathered in. I'm more concerned about a total, permanent market collapse than I am about my Roth getting taxed, and I'm really not concerned about a total, permanent market collapse.

[fiveoh]

ard to say what taxes will look like 15,10 or even 5 years from now.   Although they could change the way the Roth works as well...

No, they really couldn't... Technically, the law could be changed, but I think anyone writing tax code knows that double-taxing Roth contributors would be political suicide. They could discontinue the Roth option, but it is HIGHLY unlikely that existing Roth contributions would not be grandfathered in. I'm more concerned about a total, permanent market collapse than I am about my Roth getting taxed, and I'm really not concerned about a total, permanent market collapse.

I have no faith in the current government/political machine.  Gov spending is out of control and no one wants to do anything about it(for political career reasons like you said).  They just fight about where to make cuts and end up doing practically nothing.  IMO it's going to get put off until we are in a Greece like situation and then extreme measures will have to be taken.  Anyway i'm getting off on a rant here, just saying nothing is for sure, and you are right a market/currency collapse could happen as well.   :)

[Guitarist]

The politicians could make the Roth IRA savers out to be money hoarding, 1%'ers (which we all know would be just about the dumbest assertion ever made) and we need to get their savings because it would be only fair.
With how dumber this country is getting, I am sure it would be possible within a few generations.

But for now, they would just axe the Roth option but let you keep what you already put in, tax free.

With the changes to credit card laws coming that hurt those who actually pay off their balance and helps those who don't understand how to pay it off, I am not sure just how low our government would go.

[velocistar237]

But it seems like if you pick a Roth, you can effectively save more.

Yes, that makes sense. No, I haven't heard this before.

So, the amount saved in retirement accounts is higher, but is this better?

(One note: your $6250 number should be $6666 (*0.75=$5000), which makes your argument stronger, until we look at the big picture below.)

The alternative to investing $5000 post-tax dollars in a Roth is investing $5000 pre-tax dollars in the Traditional plus $1666*0.75 post-tax dollars in a non-retirement account. If you're in the 15% tax bracket when you retire, then with the Traditional IRA, you get ($5000+gains)*0.85 plus ($1666+gains)*0.75 minus capital gains tax, and with the Roth, you get $5000+gains.

Traditional >?< Roth
0.85*($5000+gains) + 0.75*($1666+gains-capitalgains) >?< $5000+gains
0.85*$5000*(1+R) + 0.75*$1666*(1+R*(1-CG)) >?< $5000*(1+R)

Assume a gain of 50% and capital gains of 15%.

($5000*1.5)*0.85 + ($1666*(1+0.5*0.85))*0.75 >?< $5000*1.5
$8156 > $7500

A little fiddling shows that it's pretty hard to find a case where the Roth beats the Traditional.

(1-T2)*5000*(1+R) + (1-T1)*5000*(1/(1-T1)-1)*(1+R*(1-CG)) >?< 5000*(1+R)
(1+R*(1-CG))/(1+R) >?< T2/T1

The left-hand side ranges between 1 if gains R are small or capital gains tax is low, and (1-CG) if gains are large. With large gains, the ratio of your future tax rate to your current tax rate would have to be larger than (1-CG) in order for a Roth to be better. For the above example, your future tax rate would have to exceed 0.85*25% = 21.25%.

If you're choosing between a Traditional and a Roth, and you think that the future tax rate (not just marginal, but overall, accounting for the standard deduction) will exceed 21.25% for someone in the Mustachian expense range of $30K/year (2012 dollars), then use a Roth instead of a Traditional. Otherwise, choose a Traditional. Or hedge and do a little of both.

It's still true that a Roth is better than non-retirement accounts alone.

[shedinator]

But it seems like if you pick a Roth, you can effectively save more.

Yes, that makes sense. No, I haven't heard this before.

So, the amount saved in retirement accounts is higher, but is this better?

(One note: your $6250 number should be $6666 (*0.75=$5000), which makes your argument stronger, until we look at the big picture below.)

The alternative to investing $5000 post-tax dollars in a Roth is investing $5000 pre-tax dollars in the Traditional plus $1666*0.75 post-tax dollars in a non-retirement account. If you're in the 15% tax bracket when you retire, then with the Traditional IRA, you get ($5000+gains)*0.85 plus ($1666+gains)*0.75 minus capital gains tax, and with the Roth, you get $5000+gains.

Traditional >?< Roth
0.85*($5000+gains) + 0.75*($1666+gains-capitalgains) >?< $5000+gains
0.85*$5000*(1+R) + 0.75*$1666*(1+R*(1-CG)) >?< $5000*(1+R)

Assume a gain of 50% and capital gains of 15%.

($5000*1.5)*0.85 + ($1666*(1+0.5*0.85))*0.75 >?< $5000*1.5
$8156 > $7500

A little fiddling shows that it's pretty hard to find a case where the Roth beats the Traditional.

(1-T2)*5000*(1+R) + (1-T1)*5000*(1/(1-T1)-1)*(1+R*(1-CG)) >?< 5000*(1+R)
(1+R*(1-CG))/(1+R) >?< T2/T1

The left-hand side ranges between 1 if gains R are small or capital gains tax is low, and (1-CG) if gains are large. With large gains, the ratio of your future tax rate to your current tax rate would have to be larger than (1-CG) in order for a Roth to be better. For the above example, your future tax rate would have to exceed 0.85*25% = 21.25%.

If you're choosing between a Traditional and a Roth, and you think that the future tax rate (not just marginal, but overall, accounting for the standard deduction) will exceed 21.25% for someone in the Mustachian expense range of $30K/year (2012 dollars), then use a Roth instead of a Traditional. Otherwise, choose a Traditional. Or hedge and do a little of both.

It's still true that a Roth is better than non-retirement accounts alone.

I'd say I hope you didn't do all that math on your own, but I'm pretty sure you did :).
The standard advice for IRAs goes a little something like this:
If you expect to be in a lower tax bracket when you retire, use a traditional IRA. If you expect to be in the same tax bracket, or a higher one, use a Roth IRA. The reason Roths are popular is that most people intend/hope to be in a higher tax bracket, because the picture of retirement we've had painted for us over the last 15+ years is one of expensive leisure, small business ownership, and retirement communities, based on your mythic "number" which will let you live the good life in retirement.

For folks who are committed to Frugality, the Roth may still have a benefit over the traditional. You can look at just your retirement savings and conclude that you intend to retire on an amount that will produce your current level of expenditures, which will put you in a lower tax bracket, and then be tempted to go Traditional. But, unless you are fully committed to not having any earned income, living solely off capital ganes and retirement accounts, this is probably not an accurate representation of your finances. Maybe if you're a super-saver, who earns 100k/year and lives on 13k, your earned income plus retirement yield will still result in a lower bracket. But I think for anyone in the 25% bracket or lower, a Roth still makes more sense. Of course, the choice is easy for me right now- I'm in the lowest tax bracket, so unless a lower one is created between now and when I reach FI, there's no way that a traditional IRA will beat the returns on my Roth atm.

[MDM]

Thought I had seen something in the MMM forum similar to a recent Bogleheads topic: http://www.bogleheads.org/forum/viewtopic.php?f=10&t=140758 - and finally found this old topic.

Primarily replying here to link the two discussions.

As one of the Bogleheads folks notes, if you are situated to do a tax-free Roth conversion ladder then all the "tIRA vs. Roth" comparative math is irrelevant.  Not everyone is in that situation.  Those who can't benefit from the Roth conversions may still want to choose between tIRA and Roth.

In short, the popular advice "if your tax rate doesn't change [the choice of tIRA vs. Roth] doesn't matter" is wrong in many (but not all) situations.  See above in this topic or over at Bogleheads for details.

[milesdividendmd]

If you have a long enough retirement, I would argue that your best bet is putting your $5500 in a traditional IRA.

During your retirement you can then convert chunks of your IRA savings into a Roth account at low enough levels to keep your income below the point at which you're taxed.

This is the best of all worlds. Pre-Tax money going in, tax free growth, and tax-free money coming out.

The approach is best described here:

http://www.gocurrycracker.com/never-pay-taxes-again/

Enjoy

[Jags4186]

I still think the no. 1 option for most people is to max traditional 401k max Roth IRA.  If you are sure you will be comfortable living on the equivalent of 30k/yr then you can do all traditional, but if you are going to have a slightly more fancypants retirement, or simply retire later in life with more of a stache you will be living on more money.

I don't believe you want all of your money in tax deferred accounts simply because then all of it will be taxable upon withdrawal. Yes you want more in your tax deferred accounts because it does net save you more.  However if you have Roth/taxable account options you will be able to manipulate what your tax rate is on withdrawals from your tax deferred accounts by simply not needing to withdraw enough from them to put you in a higher tax bracket.

Also remember while you nominally save more with a Roth option, "maxing out" both a Roth IRA and a Roth 401k may not be an option depending on your income.  It would cost me another 3-4k/yr to max out a Roth 401k vs my traditional and I don't think I could swing that based upon my budget/other goals.

[cjw7]

With the changes to credit card laws coming that hurt those who actually pay off their balance and helps those who don't understand how to pay it off, I am not sure just how low our government would go.

what is this about?

[Dodge]

If you have a long enough retirement, I would argue that your best bet is putting your $5500 in a traditional IRA.

During your retirement you can then convert chunks of your IRA savings into a Roth account at low enough levels to keep your income below the point at which you're taxed.

This is the best of all worlds. Pre-Tax money going in, tax free growth, and tax-free money coming out.

The approach is best described here:

http://www.gocurrycracker.com/never-pay-taxes-again/

Enjoy

Yes, I was just about to post this link:

http://www.madfientist.com/traditional-ira-vs-roth-ira/

Since they have a pretty graph :)

Investor A is represented by the light green lines and Investor B is represented by the dark green lines. The solid lines represent the investors’ normal taxable accounts, the dashed lines represent the investors’ Roth IRA accounts, and the dotted line represents Investor B’s Traditional IRA account.

As you can see, at age 40, both investors stop contributing to their accounts and begin withdrawing $18,000 per year from the taxable accounts. Investor B also begins converting his Traditional IRA into a Roth IRA at this time. Thanks to the fact that he is able to live on a reasonable income and has time to slowly convert the Traditional IRA into the Roth IRA, he is not taxed on the conversion and therefore ends up having exactly the same amount of money in his Roth IRA as Investor A does when they both reach standard retirement age.

What you’ll notice though is that Investor B actually has quite a bit more in his taxable account. Since he was able to invest pre-tax money in his IRA when he was working, he had more money to invest in the taxable account during his 30s and as a result, will end up with over $100,000 more than Investor A when he reaches retirement age!

It’s pretty incredible that a simple choice between two good options could result in a six-figure difference in retirement savings!

[milesdividendmd]

I still think the no. 1 option for most people is to max traditional 401k max Roth IRA.  If you are sure you will be comfortable living on the equivalent of 30k/yr then you can do all traditional, but if you are going to have a slightly more fancypants retirement, or simply retire later in life with more of a stache you will be living on more money.

I don't believe you want all of your money in tax deferred accounts simply because then all of it will be taxable upon withdrawal. Yes you want more in your tax deferred accounts because it does net save you more.  However if you have Roth/taxable account options you will be able to manipulate what your tax rate is on withdrawals from your tax deferred accounts by simply not needing to withdraw enough from them to put you in a higher tax bracket.

Also remember while you nominally save more with a Roth option, "maxing out" both a Roth IRA and a Roth 401k may not be an option depending on your income.  It would cost me another 3-4k/yr to max out a Roth 401k vs my traditional and I don't think I could swing that based upon my budget/other goals.

These are good points. But I do think there are a couple of points that should be clarified.

1. You can have up to $36,500 of earned income in retirement without spending a dime in taxes as long as you contribute $17,500 to a 401(k). This earned income will include pensions, actual earned income, and the amount that you roll over into your Roth from a traditional IRA.

2. You can have over $70,000 for year  in capital gains, and dividend income prior to having to pay taxes on investment income as long as you keep your earned income low enough as in number 1.

So you don't have to be comfortable living on $30,000 a year or less to take advantage of this avenue.

[milesdividendmd]

If you have a long enough retirement, I would argue that your best bet is putting your $5500 in a traditional IRA.

During your retirement you can then convert chunks of your IRA savings into a Roth account at low enough levels to keep your income below the point at which you're taxed.

This is the best of all worlds. Pre-Tax money going in, tax free growth, and tax-free money coming out.

The approach is best described here:

http://www.gocurrycracker.com/never-pay-taxes-again/

Enjoy

Yes, I was just about to post this link:

http://www.madfientist.com/traditional-ira-vs-roth-ira/

Since they have a pretty graph :)

Investor A is represented by the light green lines and Investor B is represented by the dark green lines. The solid lines represent the investors’ normal taxable accounts, the dashed lines represent the investors’ Roth IRA accounts, and the dotted line represents Investor B’s Traditional IRA account.

As you can see, at age 40, both investors stop contributing to their accounts and begin withdrawing $18,000 per year from the taxable accounts. Investor B also begins converting his Traditional IRA into a Roth IRA at this time. Thanks to the fact that he is able to live on a reasonable income and has time to slowly convert the Traditional IRA into the Roth IRA, he is not taxed on the conversion and therefore ends up having exactly the same amount of money in his Roth IRA as Investor A does when they both reach standard retirement age.

What you’ll notice though is that Investor B actually has quite a bit more in his taxable account. Since he was able to invest pre-tax money in his IRA when he was working, he had more money to invest in the taxable account during his 30s and as a result, will end up with over $100,000 more than Investor A when he reaches retirement age!

It’s pretty incredible that a simple choice between two good options could result in a six-figure difference in retirement savings!

Great point Dodge. Another all time classic post!  And your point about the sizeable monetary advantage of The traditional IRA approach is well made.

[Jags4186]

Yes I love madfientist's post.  It still works under the assumption you have extremely modest expenses and can convert traditional ira's to roth iras without paying taxes AND have a substantial amount of outside money to bridge the gap until 59.5.  It also assumes you have no PT income.  If you work PT and make 10/15k a year you can't convert your money tax free.

[Philociraptor]

Since most people will retire at 15% bracket or below, I always heard it made sense to use traditional IRA if in 25% bracket.  The problem is that if you're a bit into the 25% bracket (nearing the 28% bracket) you lose your ability to deduct contributions to the tIRA, killing the benefit and making the Roth the right choice.

For 2014:
Single filers enter 25% bracket at $36,900, but deduction phase-out beings at $60k and no deduction at $70k (MAGI, which excluses a lot of deductions)

It's even worse for married: enter 25% bracket at $73,800, deduction phase-out begins at only $96k, with no deduction at $116k (again, MAGI, with excludes most deductions).

Keep this in mind when deciding between traditional and Roth IRA's.  If you can't deduct your contributions then you may as well use the Roth / non-deductable traditional to Roth conversion.

[milesdividendmd]

Jags,

If you make 10-15k a year in earned income you can convert 2-7k a year plus the amount that you contribute to a 401k (up to 17.5k) or an IRA (up to 5.5k).

This is an important point I think.

[Jags4186]

MD,

Agreed but the point of working PT during FIRE isn't to continue contributing to retirement its to reduce your draw down of assets.  If you work PT, contribute your 5.5k to a traditional IRA and then convert 5.5K from a TIRA to a RIRA...wouldn't it make more sense at that point to just contribute to the RIRA directly? (EDIT) and that's assuming you want to contribute at all...

So I guess my point is...nominally, in perfect circumstances, it makes sense to go all traditional and do Roth conversions.  In actuality I think it would be extremely difficult to achieve the proper end game and make it worth all the hassle.

[milesdividendmd]

That an interesting point.

What I would say is that if I had a part time job in FIRE, I would contribute as much as possible to my tax deductible retirement accounts (401k vs IRA) in order to avoid taxes on my earned income now.

I would live off of my taxable accounts (paying no capital gains/dividends  up to 70+K) and rollover the  max amount of my traditional IRA to my Roth IRA without paying taxes.

In this way, I am avoiding taxes now and in the future, and I am converting taxable investments to tax sheltered accounts.

These are big wins compared to paying taxes on your income now, and contributing to a Roth directly.

[teen persuasion]

A small amount of earned income could help you convert more money to Roth money.  Say you are MFJ, and at least one of you earns $4k.  If you contribute $2k each to an IRA, and your income is under $35k, you would be eligible for a retirement savers' credit of $2k.  So rather than converting $20k tax-free, you could effectively convert up to $35k (with tIRAs), or up to $31k (with Roths).

[frugalnacho]

MD,

Agreed but the point of working PT during FIRE isn't to continue contributing to retirement its to reduce your draw down of assets.  If you work PT, contribute your 5.5k to a traditional IRA and then convert 5.5K from a TIRA to a RIRA...wouldn't it make more sense at that point to just contribute to the RIRA directly? (EDIT) and that's assuming you want to contribute at all...

So I guess my point is...nominally, in perfect circumstances, it makes sense to go all traditional and do Roth conversions.  In actuality I think it would be extremely difficult to achieve the proper end game and make it worth all the hassle.

I'm confused why you couldn't just defer 100% of your PT earned income (10-15k) into your 401k, then continue with your roth conversion ladder and draw down your assets.  You end up drawing 10-15k more off your assets (since you are deferring all that earned income), but then you are adding 10-15k to your 401k asset, and will eventually convert it to a roth and get most of your money tax free.  Seems like you get the best of all worlds and save more money in taxes.

[Jags4186]

That assumes you have a PT job that gives benefits. Again I'm not saying in theory all this stuff isn't the best solution I'm questioning the practicality.  For some this is the best method for others no.


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