Roth or Traditional uncertainty - whats better?

[AmbitiousSaver]

I have a Roth at one place and I set up a Traditional IRA with the Suze Orman "Save yourself" plan BUT then realized that I can't automatically have my paycheck fund the account pre-tax. I have to fund it with after tax dollars. So I thought perhaps I should convert the Traditional IRA to a Roth.

I went ahead and sent in the paperwork to TD Ameritrade to convert the Traditional to a Roth.

The advisor said that although I'm funding it with after tax dollars I could write the Traditional IRA on my taxes as a deduction.

Couple thoughts going through my head are... I'm in a low tax bracket now, so whatever taxes I pay now will likely be lower than what tax bracket I'm in when I retire... so a Roth would win out, right?

Also, if you have a Roth - I know you can only contribute a maximum of $5K between however many accounts you have. But I don't understand how it works if you have a Roth and a Traditional. Can you contribute $5K to each?

Is the tax break right now for a traditional IRA worth it or is a Roth the best way to go all around?

[noppenbd]

There are differing opinions on this. Here is mine:

If you are in a low tax bracket now and see your expenses higher later on OR
you are in a low tax bracket now and see overall tax rates going higher

then the Roth is the way to go. Total contributions to IRAs (Roth, traditional, or nondeductible) cannot exceed $5000 for this year per person. So you could put $1 in your traditional and $4999 in your Roth(s), or whatever combination you want.

Personally I see tax rates going in higher in the future so I prefer to fund a Roth even though my tax bracket is currently 25%. We also fund some work plans (i.e. 401k) which are pretax dollars so that will give us some flexibility when we start to make withdrawals. For instance we could withdraw just enough from the pretax plans to keep us in a low tax bracket and then fund the remainder of our expenses with Roth withdrawals.

Besides tax flexibility, the other benefit to the Roths is something you alluded to. Since the contributions are the same for the Roth and the traditional, but the Roth is funded with after tax dollars, you are essentially putting more in the Roth if you max out. A Roth account with balance of $5000 is "worth" more than a traditional IRA with the same balance. Pulling $5000 out of the tIRA only gives you $4000 of spendable money, in other words.

[jIM_Ohio]

You need to make sure you know what you are talking (asking) about. I understood about 75% of your post.

I did not fully understand the question. Also know that tax planning is not easy. You can either take general advice (consensus here will tell you to use the Roth) or think, plan and see if the Roth will really save you money.

So I will back up. What tax bracket are you in now (15%, 25% or 28%). Use the taxable income on your 2007 tax return to calculate this.

If in 15% tax bracket (65100 married filing jointly or 32550 single) then I would suggest using Roth.

If in 25% tax bracket (less than ~131k mfj or ~78k single) either/or

If in 28% tax bracket or higher (more than more than 78k single or 131k mfj) use the deducatable IRA.

The way deductions work is the higher the tax bracket, the higher the deduction.

If you contribute 5k to a traditional DEDUCTABLE IRA, you will get the following back:

15% bracket is $750
25% bracket is $1250
28% bracket is $1400

In all cases you must read IRS pub 590 to make sure you qualify for the deduction. The same $5000 was contributed in all cases.

Then as you pointed out, if you think tax brackets will go up in future for you- for example if your taxable income is 77k now as a single person, you know that future income will be taxed at 28% and not 25%, then the Roth makes sense MAYBE. If you are single and making just under 32k taxable income (15% bracket) and you know raises will be pushing you to 25% tax bracket the Roth makes more sense than previous case PROBABLY.

Here is my logic:
Do EVERYTHING you can to stay in 15% tax bracket. Meaning if in 25% bracket, use the deductable IRA and see if deductions move you into 15% bracket. Then once in 15% bracket, cap out the bracket income by converting a traditional IRA to a Roth IRA, but only convert up to top of 15% tax bracket.

75% of this country earns in 15% tax bracket. If you are one of the other 25%, My suggestion would be to take the deduction NOW and worry about taxes LATER. If you are in the 75% which earns in the 15% tax bracket, the Roth makes great sense.

If in 25% bracket (the bracket between 15% and 28%) you need to decide if you are likely to see income move down to 15% or up to 28%.

If income is moving down- take the deduction NOW.
If income is moving up, consider the deduction and consider the Roth. I would lean towards Roth based on withdraw rules.

There are two types of traditional IRAs- a deductable IRA and a non deductable IRA. You fund both with money in your checking account. The deductable IRA will get you money back when you file your tax return. The non deductable IRA will grow tax free. Both types are subject to RMDs at age 70.5. The Roth is NOT subject to RMDs at age 70.5.

[disneysteve]

Also, if you have a Roth - I know you can only contribute a maximum of $5K between however many accounts you have. But I don't understand how it works if you have a Roth and a Traditional. Can you contribute $5K to each?

Jim gave a great answer to most of your questions but this one wasn't addressed yet.

You can contribute a total of $5,000 in 2008 to any IRA plan, traditional or Roth. You can split the money how ever you'd like, but the total can't exceed $5,000. It is not $5,000 for a Roth and another $5,000 for a traditional. It is $5,000 total.

Keep in mind, though, that both you and your husband can each put in $5,000, so $10,000 total for the two of you.

[noppenbd]

As you can see, there are many fine points on the decision between Roth IRA and traditional, many of them dealing with unknowable answers (what will tax rates be in the future, what will your income/expenses be in the future?).

That is why many would benefit from practicing tax diversification. The idea is that if you are already putting money away pretax (401ks, SIMPLE IRAs, SEPs, etc) than putting additional money into the Roth is a good idea, because you will have flexibility at retirement. This can be accomplished through Roth contributions or converting traditional IRAs to Roths, as Jim suggested.

Personally I find it difficult to believe that significant amounts of traditional IRA monies will be able to be converted to Roth while staying in 15% tax bracket. Part of the problem is that many deductions that help people stay in the 15% bracket will disappear as they age (mortgage interest, student loan interest). Incomes tend to rise as well, making it harder to stay well below 15% bracket.

[jIM_Ohio]

Personally I find it difficult to believe that significant amounts of traditional IRA monies will be able to be converted to Roth while staying in 15% tax bracket. Part of the problem is that many deductions that help people stay in the 15% bracket will disappear as they age (mortgage interest, student loan interest). Incomes tend to rise as well, making it harder to stay well below 15% bracket.

Keep in mind the 15% bracket threshold goes up every year. A person needs to consider (as part of a tax plan) if their goal is to stay in the 15% tax bracket or see themselves in a higher bracket based on the circumstances you suggested (losing deductions).

Also keep in mind there is a standard exemption which is used more often than itemizing, and that 75% of the US tax payers pay only tax into 15% tax bracket.

Meaning the itemized techniques are not the only way to stay in the 15% bracket. If passive income comes from dividends or long term gains, this income does not raise taxable income (it is added in on another line).

I think about it this way- My fixed expenses are well within 15% tax bracket. Many of my wants and desires are what put me in 25% bracket territory. And in reality our gross income is approaching 28% which is more likely for us than being in 15%. But if I know in retirement my fixed expenses will be in 15% bracket, the fun stuff could be paid for from other (non income) sources like dividends and capital gains, allowing more money to work for me, instead of paying the same in taxes.

$A in a Roth is > $A in a dividend fund =$A in growth fund> $A in a 401k.

The balance sheet says $A in all 4 cases. But the spending power of the Roth and taxable accounts is much higher (because of taxes).

[noppenbd]

Keep in mind the 15% bracket threshold goes up every year. A person needs to consider (as part of a tax plan) if their goal is to stay in the 15% tax bracket or see themselves in a higher bracket based on the circumstances you suggested (losing deductions).

Also keep in mind there is a standard exemption which is used more often than itemizing, and that 75% of the US tax payers pay only tax into 15% tax bracket.

Meaning the itemized techniques are not the only way to stay in the 15% bracket. If passive income comes from dividends or long term gains, this income does not raise taxable income (it is added in on another line).

I think about it this way- My fixed expenses are well within 15% tax bracket. Many of my wants and desires are what put me in 25% bracket territory. And in reality our gross income is approaching 28% which is more likely for us than being in 15%. But if I know in retirement my fixed expenses will be in 15% bracket, the fun stuff could be paid for from other (non income) sources like dividends and capital gains, allowing more money to work for me, instead of paying the same in taxes.

$A in a Roth is > $A in a dividend fund =$A in growth fund> $A in a 401k.

The balance sheet says $A in all 4 cases. But the spending power of the Roth and taxable accounts is much higher (because of taxes).

Jim, dividend and LT capital gains are only a factor for taxable holdings (non-IRA). I suspect most people at low end of 25% bracket do not hold the majority of their monies in taxable holdings, so expecting a large portion of retirement income to come from them is not realistic. As you know, LT capital gains & dividends within traditional IRAs & 401ks are taxed like ordinary income when withdrawn.

In an ideal world, everyone would split monies between pre-tax, Roth, and taxable to get maximum flexibility.

[jIM_Ohio]

Jim, dividend and LT capital gains are only a factor for taxable holdings (non-IRA). I suspect most people at low end of 25% bracket do not hold the majority of their monies in taxable holdings, so expecting a large portion of retirement income to come from them is not realistic. As you know, LT capital gains & dividends within traditional IRAs & 401ks are taxed like ordinary income when withdrawn.

In an ideal world, everyone would split monies between pre-tax, Roth, and taxable to get maximum flexibility.

That is why a tax plan, withdraw plan, and savings plan are all key pieces of a financial plan. If you save you really don't have a comprehensive financial plan, just a more complex problem later.

If you are putting money into accounts blindly, expect to be blinded by a rule or two when you go to pull money out.

[maat55]

To answer your question about funding your traditional IRA with after tax money, It doesn't matter if you get the money from your employer then invest it. You just show it on your 1040 when you file. You may want to adjust your withholdings a little to compensate.