Trad vs. Roth IRA account for windfall

[fluffmuffin]

I'll be receiving an inheritance soon, and am planning to use part of it to max my IRA contributions for 2017 and 2018. I have both a Roth with Fidelity (started during my first job out of college) and a traditional with Vanguard (started this year). Which one should I dump the money in? Does it matter? It seems hinky to me that I could get the tax benefits of a traditional with inherited money, and I don't want to accidentally screw myself over come tax season.

If it's helpful, the Roth has a balance of ~$8k and the traditional is like, $400 since I just started it in September and only contribute a nominal amount. (I also have accounts through work, which is where the bulk of my retirement savings are happening--the new IRA is more to build the habit of regular "extra" retirement contributions.)

Thanks in advance!

[SeattleCPA]

If you're going to invest in stocks, keep in mind that you can have a couple of million up to maybe five million in a taxable account and, if you're married and have some deductions, pay zero income taxes because your income may all be qualified dividends income and long-term capital gain.

P.S. I would always do what's 'required' to get the employer match though...

[fluffmuffin]

If you're going to invest in stocks, keep in mind that you can have a couple of million up to maybe five million in a taxable account and, if you're married and have some deductions, pay zero income taxes because your income may all be qualified dividends income and long-term capital gain.

P.S. I would always do what's 'required' to get the employer match though...

Hmm, not sure what you're getting at, sorry. I'm definitely not working with millions here, unfortunately :) Not sure if that changes your answer--I've been operating under the impression that you max tax-advantaged vehicles like IRAs before getting into taxable accounts. Is there a reason you're suggesting a taxable account over an IRA?

I'm already contributing to max my employer match, fortunately.

[ixtap]

If a traditional IRA is beneficial to the rest of your situation, remember that money is fungible. You can spend your inheritance and use your earned income to fund the IRA.

[dandarc]

. . . money is fungible . . .

This - your inheritance dollars look no different than dollars that came from your job, so there should be no legal or ethical hangups with going traditional, Roth or otherwise as your circumstances dictate.

So make your traditional / Roth decision the usual way - if you're eligible to deduct the tIRA at your income level, then you're looking at marginal rate today vs. expected marginal rate tomorrow.

[fluffmuffin]

Thanks ixtap and dandarc! The note about money being fungible makes sense, thanks--that's what my brain needed in order to wrap itself around the traditional being an okay vehicle for this.

[SeattleCPA]

If you're going to invest in stocks, keep in mind that you can have a couple of million up to maybe five million in a taxable account and, if you're married and have some deductions, pay zero income taxes because your income may all be qualified dividends income and long-term capital gain.

P.S. I would always do what's 'required' to get the employer match though...

Hmm, not sure what you're getting at, sorry. I'm definitely not working with millions here, unfortunately :) Not sure if that changes your answer--I've been operating under the impression that you max tax-advantaged vehicles like IRAs before getting into taxable accounts. Is there a reason you're suggesting a taxable account over an IRA?

I'm already contributing to max my employer match, fortunately.

I was just trying to point out that if your marginal tax bracket isn't 25% or higher--in other words, you're in and will stay in either the 10% or 15% bracket--your qualified dividends and long-term capital gains get taxed at the 0% rate .

In this situation, you may get little tax savings or no tax savings from pushing money into a Roth and you may actually bump your taxes  down the road by pushing money into a regular IRA or 401(k).

Example: You're single and making $50,000 but with a $6K-ish standard deduction, a $4K-ish personal exemption and a $10K-ish 401(k) contribution, your taxable income equals $30,000.

That leaves roughly $8K of "space" in the 15% tax bracket. If you got a $300K windfall and you invest the money into Vanguard total stock market and it generates $8K a year of qualified dividends and long-term capital gains, you aren't going to pay any income taxes on the $8K. It'll all be taxed at 0%.

Sorry for being confusing...

[fluffmuffin]

Ahhh thanks SeattleCPA, I think I see what you're saying now. I have a very 101-level understanding of investments and need like, remedial instruction in long-term tax planning, so the clarification is much appreciated :)

I'm in the 15% bracket for the foreseeable future and my income/deductions aren't too far off from your example. So what I'm hearing is that you think it would make more sense for me to put ~$11k into VTSAX rather than an IRA from a tax perspective, because I'd have to make over $8,000 in qualified dividends or capital gains before I'd have to pay income taxes on them. Distributions from that same $11k put into a regular IRA would be taxed on withdrawal, and a Roth would be a wash. In that case, what's the tax advantage of VTSAX over the Roth?

[dandarc]

VTSAX is a mutual fund.

A Roth IRA is a type of account.  You can hold VTSAX within a Roth IRA.  Roth IRA would lock in "no tax down the road", but has a bit less flexibility than a taxable account until you've reached 59.5.

With a Roth IRA, you can withdraw your contributions tax and penalty free at any time.  In a taxable account, obviously you can access all of the account at any time, paying any tax that may be due.  SeattleCPA has pointed out, even if you have gains when you withdraw, the tax rate may well be 0%. If your LTCG and qualified dividend rate remains zero for your entire holding period, then you've got the same tax paid as you would have with the Roth.

Investing 101 - read the stock series http://jlcollinsnh.com/stock-series/, this one specifically talks about the different account types http://jlcollinsnh.com/2015/06/02/stocks-part-viii-the-401k-403b-tsp-ira-roth-buckets/

[SeattleCPA]

VTSAX is a mutual fund.

A Roth IRA is a type of account.  You can hold VTSAX within a Roth IRA.  Roth IRA would lock in "no tax down the road", but has a bit less flexibility than a taxable account until you've reached 59.5.

With a Roth IRA, you can withdraw your contributions tax and penalty free at any time.  In a taxable account, obviously you can access all of the account at any time, paying any tax that may be due.  SeattleCPA has pointed out, even if you have gains when you withdraw, the tax rate may well be 0%. If your LTCG and qualified dividend rate remains zero for your entire holding period, then you've got the same tax paid as you would have with the Roth.

Investing 101 - read the stock series http://jlcollinsnh.com/stock-series/, this one specifically talks about the different account types http://jlcollinsnh.com/2015/06/02/stocks-part-viii-the-401k-403b-tsp-ira-roth-buckets/

+1

[fluffmuffin]

Thanks for the continued clarification and resources. So it looks like the correct choices are a taxable investment in VTSAX, or opening a new Roth with Vanguard and investing in VTSAX that way. Any thoughts on which is more advantageous, since it sounds to me like they're going to be functionally the same in my situation? I don't plan to touch this money prior to retirement and so don't really care about the flexibility.

[SeattleCPA]

Thanks for the continued clarification and resources. So it looks like the correct choices are a taxable investment in VTSAX, or opening a new Roth with Vanguard and investing in VTSAX that way. Any thoughts on which is more advantageous, since it sounds to me like they're going to be functionally the same in my situation? I don't plan to touch this money prior to retirement and so don't really care about the flexibility.

If it were me, I would skip the complication of the Roth and keep open the option of being flexible. Along the path of life, you'll maybe have opportunities that a chunk of liquid, easily accessible assets make possible.

Two concrete examples of this...

1. If the stock market corrects big time next year and your windfall loses, say, 30% of its value, you can sell the VTSAX to harvest a capital loss, reinvest the proceeds in some other low cost high quality equity mutual fund, and then put a $3000 capital loss deduction on your tax return every year until you burn off the capital loss. (E.g., your windfall equals $30,000 and you tax loss harvest a $9K capital loss... in this case, you'll put a $3K capital loss on next three years of tax returns.)

2. I hesitate to open this can of worms, but while index funds and tax deferred retirement accounts are really the "best practices" way to march toward financial independence, IRS wealth statistics show (suggest?) that people also achieve financial independence by having the resources available to make very opportunistic investments. BTW, I am not saying you should use your windfall money as the down payment on a Jimmy Johns franchise... but I think it's possible if you keep your eyes open that in 8 years and then again in 26 years, you'll get opportunities to earn really good returns if you have cash available.

[fluffmuffin]

If it were me, I would skip the complication of the Roth and keep open the option of being flexible. Along the path of life, you'll maybe have opportunities that a chunk of liquid, easily accessible assets make possible.

Two concrete examples of this...

1. If the stock market corrects big time next year and your windfall loses, say, 30% of its value, you can sell the VTSAX to harvest a capital loss, reinvest the proceeds in some other low cost high quality equity mutual fund, and then put a $3000 capital loss deduction on your tax return every year until you burn off the capital loss. (E.g., your windfall equals $30,000 and you tax loss harvest a $9K capital loss... in this case, you'll put a $3K capital loss on next three years of tax returns.)

2. I hesitate to open this can of worms, but while index funds and tax deferred retirement accounts are really the "best practices" way to march toward financial independence, IRS wealth statistics show (suggest?) that people also achieve financial independence by having the resources available to make very opportunistic investments. BTW, I am not saying you should use your windfall money as the down payment on a Jimmy Johns franchise... but I think it's possible if you keep your eyes open that in 8 years and then again in 26 years, you'll get opportunities to earn really good returns if you have cash available.

Cool. I'll skip the Roth then. Thanks for talking through all of this with me, I really appreciate the guidance!

I'll admit to being gun-shy about opportunistic investments because I have one parent who's always chasing them and ending up burned and broke...my financial role model is my other parent, who drummed into my head from an early age that the way to financial stability is to save, live frugally, and minimize risk (not "keep all your money in a savings account and never invest," but "be very wary of anything offering you a financial return that seems too good to be true"). I know I need to work on finding a happier medium.

[SeattleCPA]

If it were me, I would skip the complication of the Roth and keep open the option of being flexible. Along the path of life, you'll maybe have opportunities that a chunk of liquid, easily accessible assets make possible.

Two concrete examples of this...

1. If the stock market corrects big time next year and your windfall loses, say, 30% of its value, you can sell the VTSAX to harvest a capital loss, reinvest the proceeds in some other low cost high quality equity mutual fund, and then put a $3000 capital loss deduction on your tax return every year until you burn off the capital loss. (E.g., your windfall equals $30,000 and you tax loss harvest a $9K capital loss... in this case, you'll put a $3K capital loss on next three years of tax returns.)

2. I hesitate to open this can of worms, but while index funds and tax deferred retirement accounts are really the "best practices" way to march toward financial independence, IRS wealth statistics show (suggest?) that people also achieve financial independence by having the resources available to make very opportunistic investments. BTW, I am not saying you should use your windfall money as the down payment on a Jimmy Johns franchise... but I think it's possible if you keep your eyes open that in 8 years and then again in 26 years, you'll get opportunities to earn really good returns if you have cash available.

Cool. I'll skip the Roth then. Thanks for talking through all of this with me, I really appreciate the guidance!

I'll admit to being gun-shy about opportunistic investments because I have one parent who's always chasing them and ending up burned and broke...my financial role model is my other parent, who drummed into my head from an early age that the way to financial stability is to save, live frugally, and minimize risk (not "keep all your money in a savings account and never invest," but "be very wary of anything offering you a financial return that seems too good to be true"). I know I need to work on finding a happier medium.

Actually, I'll happily stipulate your financial role model is who you should follow... :-)