Roth IRA or Traditional IRA

[shooter47]

Just got my W-2 from work today and ran the numbers through one of those on line calculators. My AGI is 49000, I 23 years old and single and will use the standard deduction of 5,700 and personal exemption of 3650 lowering my taxable income to 39650. I had 6210 dollars withheld for federal taxes this year and would get roughly 500 dollars back in a refund.

This leads me to my question. I have not made my IRA contribution for 2010 and was planning on putting 5,000 into a Roth IRA. I started my first 401k in january of last year and contributed 6800 dollars into it this year(which has 10,000 dollars in it currently due to employeer contributions and gains.)I am now considering to put the 5000 dollars i have saved up into a Traditional IRA instead of the Roth IRA I had planned. If I did the Roth IRA I would not get any additional money in my tax refund but the future withdrawals would be tax free. The Traditional IRA would be tax deductible and since I am in the 25% tax bracket would raise my tax refund 1250 dollars but the withdrawals in the future would not be tax free. I would plan on taking the 1250 extra I received in my refund and open a taxable brokerage account and buy a total stock market index fund If i do the Traditional IRA.

I guess what I am asking is what would you do in my situation, contribute to the Traditional and take the instant 25% gain on the IRA contribution or contribute to the Roth IRA where you get no instant gain but the money won't be taxed in the future?

[Savoir Faire-Demogague in NJ]

If you went traditional IRA this year, you would essentially earn 25% on the deposit in the first year. That would be the tax savings.
There are many viewpoints on the topic of traditional IRA vs Roth. My view is to take advantage of any tax deferrals as long as they are available to you.
I am in a position where I can max out my 401K contributions as well as the over 50 catch-up contributions. I only qualify for the Roth IRA and my income is just under the phase out point, so I contribute the max to my Roth while I qualify to do so.
This is my take, let's see what others have to offer.

[Kung Fu Panda]

you cannot contribute to a tax free traditional IRA if you contribute to a employer sponsored 401k

[phil5185]

If you are a part of a qualified 401k plan, you are not eligible for a Trad IRA deduction. (You can contribute to a Trad IRA but no deduction, so it would be of no use).

To accomplish your goal, you would have had to contribute the extra $5000 to your 401k before Dec 2010.

[Savoir Faire-Demogague in NJ]

you cannot contribute to a tax free traditional IRA if you contribute to a employer sponsored 401k

Depends on one's income level. This is my understanding.

[shooter47]

Jan 31, 2011 12:54:08 GMT -5 Kung Fu Panda said:

you cannot contribute to a tax free traditional IRA if you contribute to a employer sponsored 401k

According to this from the IRS:

www.irs.gov/retirement/participant/article/0,,id=188235,00.html

Since I have an AGI below 56,000 I can still deduct the entire contribution even while being covered by an employer sponsored 401K.

[Savoir Faire-Demogague in NJ]

Here is a link to a site that does some explaining...

www.money-zine.com/Financial-Planning/Retirement/Traditional-IRA/

[Deleted]

OP,

i would contribute to a traditional IRA if i were you.

[Kung Fu Panda]

ok, good catch.
The future income on that 5k over 40 years will be a lot more than the 1200 refund. Think of of the rule of doubles..at 7% growth your investment doubles in 10 years. Thats 4 doubles = 80k tax free...

[Plain Old Petunia]

I suggest you do BOTH, Shooter. You can contribute to both, you just can't go over 5k in total. Someday, it will be good to have both pots of money. If you have your eye on a fund with a 3k minimum, then do 3k/2k (choose something else for now with the 2k).

Congrats on being mature and smart enough at only 23 to be thinking long-term.

[shooter47]

Jan 31, 2011 13:06:47 GMT -5 Kung Fu Panda said:

ok, good catch.
The future income on that 5k over 40 years will be a lot more than the 1200 refund. Think of of the rule of doubles..at 7% growth your investment doubles in 10 years. Thats 4 doubles = 80k tax free...

This is true but if I invest the 1250 from the tax refund in a brokerage account and it earns the same percent over 40 years the total account value will be 25% greater([6250/5000]*(1+i)^n)

I guess it boils down to wether or not I think the Income tax and Capital gains tax will be in 40 years compared to the 25% I would pay today.

[phil5185]

This is true but if I invest the 1250 from the tax refund in a brokerage account and it earns the same percent over 40 years the total account value will be 25% greater([6250/5000]*(1+i)^n)

At last - someone who does math!! For years I've tried to point out to the 'convert to a Roth' crowd that the 'outside' money grows too.

Regarding the tax - during the 50+ yrs that I have been in the market, there was only one brief period where capital gains tax didn't get preferential treatment compared to ordinary income tax. But no one can predict tax code, it could be anything in 40 yrs - Flat, Fair, yada. So you must use all 3 tax status accounts to diversify tax status, just as you diversify investments. (At age 65, you don't want to find yourself 100% in the wrong tax status).