patrick.net

Yes, you've hit on one of the big reasons the calculation isn't so simple.

Here's another one: You can structure how you receive the income from a traditional IRA so that you take less taxes. For example, you can limit what you take in a given year to lower your taxes for that year.

Some of my friends have hedged and put 50% in Traditional and 50% in Roth.

Somehow the rest of my post got clipped...but you hit on some of my other questions, too.

1. Is there wisdom in hedging and putting 1/2 in one and 1/2 in the other. Hedging against future tax uncertainty, for one...and also noting that some of the flexibility advantages (not being forced to take a distribution) have diminishing value. (It's great to not have to have a forced distribution for 1/2 of your money, but less valuable for the other half...most are going to want to take some distributions anyway)
2. Is there a motivation to invest your traditional IRA more conservatively than your Roth IRA (while still achieving your desired level of diversification)...since the traditional IRA will be taxed, and your Roth won't.
3. Can you "game" the system by taking 1/2 of your income from a traditional and 1/2 from a Roth..minimizing the tax penalty of a traditional, and maximizing the tax advantage of the Roth (since you will be taxed on 1/2 of your total distribution, which would fall in the lower tax brackets...all of your Roth distribution will have the advantage of avoiding the higher tax bracket rate)

etc., etc.

So, in deciding what types of investment vehicle to use, I have to consider all of this...And right now it seems like some mix is best.

One perceived advantage of the Roth is that you can contribute more value in a given calendar year since they have the same $ limits but different tax rules. I'm not sure how that all works out if you invested the difference in a non-sheltered account (and really had the discipline to leave it alone)...

For me I think I have more $$ to put in than I have room to work with, so I'm leaning towards contributing to all of my accounts (401k, IRA (x2), SEP 401K (spouse)) as Roth (to get the maximum value in the tax advantaged acct), but only if it makes sense...

SFace says

In a 401K, if I contribute 10K, I get 10K in working capital. In a roth IRA, i get to start off at 6K instead of 10K because 4K went to uncle sam and auntie sally.

Well, be careful there.

Let's say your marginal tax rate in both cases is 20%, just for simplicity.

If I put in $5K in my Traditional IRA. I get a present deduction and pay 20% less tax today. Then let's say my IRA gains 150% before I retire, and then I pay 20% tax. That means I will have $12,500 and then will pay 20%, netting $10K.

Let's say I instead put $4K in my Roth, which is based on $5K present income. Then my IRA gains 150%, so I have $10K.

I'm in the same net position. The difference is that I can actually put $5K in my Roth, so it's like having a Traditional IRA of $6250.

However, note that the Traditional IRA still lets you pay the 10% and 15% brackets on withdrawals, and you can structure the withdrawals too.

With very few exceptions people are way better off with Roth IRAs. Most financial consultants won't have the balls to say this, but it's true. Roth IRAs are almost always superior to traditional IRAs and when they are not, the difference is insignificant.

The few situations where the traditional IRA is better are ones that go like this. You are a few years from retirement; your income over the last few years of your career is going to drop; and you plan to hold the IRA for a short time. And in those situations the benefits of the traditional IRA are relatively small.

What makes the Roth IRA superior is that, although you contribute with after-tax dollars, the investment grows tax free.

While the traditional IRA saves you taxes on the money you put in, the Roth IRA saves you taxes on the entire growth of they money over decades. This is a lot more savings. A hell of a lot.

In fact, the Roth IRA is such a good vehicle for retirement savings, I'm in favor of completely getting rid of the traditional IRA and the 401K plan and all other such plans in exchange for letting everyone contribute up to $100k in year 2000 dollars per year in Roth IRAs regardless of their income. Such a super Roth IRA would render all other retirement investments obsolete. [For the 401K employer matching contributions, which are voluntary and rare, those would become matching Roth IRA contributions.]

I would also strongly recommend converting any traditional IRA you have into a Roth IRA unless you're only a few years away from retirement. I rolled over my traditional IRA into my Roth IRA years ago.

Traditional IRA vs. Roth IRA - Which is Better has a good summary of the differences between the two types of IRAs.

As a side note, for investing in IRAs, I'd recommend Vanguard. This mutual fund company is geared towards long-term investors and features the lowest costs in the industry. It was founded by John Boggles, the inventor of the index fund and a strong proponent of low-cost, indexed investing. Even if you like short-term investing and timing the markets, for retirement accounts, you really have to be a long-term investor to succeed.

corntrollio says

The difference is that I can actually put $5K in my Roth, so it's like having a Traditional IRA of $6250.

That's the "problem" I'm having. Partly because I have been very frugal lately, partly because I didn't contribute to my IRA last year (I had some risks to hedge against. They didn't come to pass, but it seemed prudent) which left me with excess $....So I have the funds to add to my accounts, the desire to do so (and make up for missing last year), so I am bumping into my contribution limits...so that extra value that I can put into the Roth matters...I just don't want to pay too much of a premium to access it.

Maybe I will try to do the analysis of traditional + non-sheltered compared to all Roth (both options funded with the same amount of pre-tax $).

In the end I guess it's just complicated, and there in most cases there is no "right" decision (too many unknowables, like future tax rates, etc)...that's why hedging feels right to me. I just want to make sure I'm not make a bad decision...

Dan8267 says

What makes the Roth IRA superior is that, although you contribute with after-tax dollars, the investment grows tax free.

While the traditional IRA saves you taxes on the money you put in, the Roth IRA saves you taxes on the entire growth of they money over decades. This is a lot more savings.

That is not how I understand it. My understanding is that both the traditional and Roth grow tax free. The traditional is taxed when you take a distribution, whereas the Roth is not. (And, of course, the traditional is not taxed when you make a contribution, but the Roth is). The growth in both cases is not taxed.

Wikipedia: http://en.wikipedia.org/wiki/Traditional_IRA

"With both types of IRA, transactions inside the account (including capital gains, dividends, and interest) incur no tax liability."

Yeah, I should clarify. When you take money out of a Roth IRA after reaching the required age, it's all tax free. But with the traditional IRA, you pay taxes on what you take out. The traditional IRA is "taxed deferred" and the Roth IRA is tax-free after the contributions.

I hope that's clearer.

swebb says

Wikipedia: http://en.wikipedia.org/wiki/Traditional_IRA

Also, seriously? Don't take financial advice from Wikipedia. When will people learn?

What's next? Medical advice from Wikipedia? I've read that eating Twinkies cures cancers and that high fructose corn syrup is actually good for you since it's made from corn, a vegetable.

Dan8267 says

Also, seriously? Don't take financial advice from Wikipedia. When will people learn?

What's next? Medical advice from Wikipedia?

Or real estate and investment advice from anonymous posters on forums? :)

I kid, I kid!

swebb says

"Again, if the taxpayer were in the same tax bracket before and after retirement, there would be no benefit or advantage to either IRA."

Note that your social security benefits become taxable once your income plus one half social security benefits exceeds $32,000 for married couples and $25,000 for other tax payers with up to 85% of your benefit taxable that total reaches $44,000 for married couples and $34,000 for other filers.

Traditional IRA (401k, etc.) distributions count as income under the formula; so sustaining a middle class lifestyle with such savings can effectively incur a 46.25% marginal rate among people in the 25% bracket.

Obviously the government is free to change the rules at any time and some diversification might be prudent as a hedge against that.

Dan8267 says

Also, seriously? Don't take financial advice from Wikipedia. When will people learn?

The Wikipedia reference was just a convenient place to point to. And, it happens to be right as far as I can tell. From re-reading your original post, and your "clarification" response, my conclusions is that you didn't really understand what you were talking about. Your defensive posture supports this, as well.

Dan8267 says

What makes the Roth IRA superior is that, although you contribute with after-tax dollars, the investment grows tax free.

While the traditional IRA saves you taxes on the money you put in, the Roth IRA saves you taxes on the entire growth of they money over decades. This is a lot more savings. A hell of a lot.

Sorry, that's not fully accurate. Please read the post directly above yours which explains that pre-tax is the same as post-tax if the tax rates are the same. http://patrick.net/?p=1103806#comment-772165

Think about it mathematically, if there is a 20% tax rate, you'd multiply by 0.8 to get the post-tax amount. If there is 150% growth, you would multiply by 2.5 to get the amount after investment growth. It doesn't matter if you multiply by 0.8 first or 2.5 first, you get the same answer either way.

Roth has other benefits, e.g. you can withdraw principal at any time without penalty (since you already paid tax on it). You can pull out money under certain other circumstances if you meet the exception. And as I mentioned above, you may be able to put more money into it.

However, post-tax and pre-tax don't matter if the rate is the same. If the rate will be different at present vs. at retirement, then pre-tax vs. post-tax does matter.

drew_eckhardt says

Traditional IRA (401k, etc.) distributions count as income under the formula; so sustaining a middle class lifestyle with such savings can effectively incur a 46.25% marginal rate among people in the 25% bracket.

Will you please show your math here? I'm inclined to go with SFAce's explanation on this. How did you get from 25% to 46.25%? Wouldn't the effective rate change depending on how much your Social Security to IRA income ratio is? First of all, the taxation here is phased in, if I remember correctly, and there's a bracket where up to 50% is taxable and a bracket where up to 85% is taxable. If you have other investment income, it could easily push you into one of these brackets already.

Here's a reference and it has a link to a calculator for the taxes (if applicable):

http://moneyover55.about.com/od/preretirementplanning/a/taxessocialsecurity1.htm

Controllio is right. In my case for example, the higher amount that I can put in a 401K type investment (403b actually), because it is before tax, at least offsets it being taxable when I withdraw. And arguably, with lower tax rates later, because my income is lower, not because tax rates will be lower,the Roth is actually a worse option for me.

But I would agree, that if you are comparing putting amount X in a Roth versus the same amount X in a 401K, or traditional IRA, then yes the Roth is better.

But then that comparison doesn't make sense, unless you are bumping up against your max, because the amount you have to earn, say to put 5000 in a Roth IRA is significantly more than you have to earn if you get to sock the 5000 away before taxes.

Controllio said the same thing in a different way above. In his example, the same amount of earnings is invested, but that is 20% less into the Roth, since it is after tax.

Note: even if you are at your max, you will have to earn significantly more, to put 5000 in a Roth than you will have to earn to put the same amount in a traditional IRA or 401K. Any legitimate comparison must take this in to account.