Roth IRA vs a Taxable brokerage acount

[MKKShah]

I am now considering setting up a Roth IRA, based on the strong recommendations in it's favor by forum members. However, I am already contributing a fairly large amount in my 401(k), and believe that contributions, at that level, over a fairly long period, will be sufficient for my retirement (I am 31 now).

So I will be looking towards a Roth IRA not as a retirement account, to be tapped at retirement, but something I might most likely withdraw before I am 59 and 1/2.

I am trying to understand the tax implications of a complete withdrawal from the Roth IRA and see how that fares had I invested the same money through a regular taxable brokerage account.

Assumptions:
- I am investing $1000
- I make the following trades in succession:
- Purchase stock X, and hold for 1 yr and 1 day, @ 10% gain
- Use proceeds from above less taxes to purchase stock Y, and hold for 1 yr and 1 day, @ 10% gain
- Use proceeds from above less taxes to purchase stock Z, and hold for 1 yr and 1 day, @ 10% gain
- Let's discount transaction costs (assume them to be the same)

Taxable brokerage account scenario:
- Start with $1000
- Invest $1000 in X.
- Sell for $1100. Taxable income, taxed as capital gain, is $100.
- I have $1085 after taxes
- Invest $1085 in Y
- Sell for $1194. Taxable income, taxed as capital gain, is $109.
- I have 1177.65 after taxes
- Invest $1177.65 in Z
- Sell for $1296. Taxable income, taxed as capital gain, is 118.35.
- I have $1278. No taxes owed on this at this point.

So I have my original $1000. And an after tax gain of $278.

In a Roth IRA:
- Start with $1000
- Cash in account after the 3 trades = 1000 X 1.1 X 1.1 X 1.1 = $1331

Here again, I have my original $1000. And a pre-tax gain of $331.

A 10% early withdrawal fee costs me $33.1. So I am left with $297.9.

If my marginal tax rate is 25%, what kind of taxes will I be paying on $297.9? Regular income tax? or Capital gains tax?

Even with capital gains tax, I am left with $253. i.e, approximately 9% less than what I would have had with the regular brokerage account.

Is it right to conclude that a Roth IRA will be generally disadvantageous for my purposes?

[Mr Nice Guy]

A Roth is for retirement, a brokerage is not. You are comparing apples to oranges.

[BuckyBadger]

A Roth is a no-brainer for all the reasons I posted in the other thread PLUS the fact that you can withdraw your principle at ANY TIME with NO PENALTY.

So lets say that over the next ten years you put $50,000 into your Roth. In that time, your account made some money and now you have $60,000 in the account. You can, at any age and at time and without any penalty take out that $50,000 that you put in.

Now, this is not something that most of us would recommend, since you can never replace that money due to the yearly limits and you end up losing all the compounding power that that money was exerting for you.

I promise you that there is practically NEVER a reason to open a taxable account unless you have maxed out ALL of your tax advantaged space already.

Also, to touch on what Mr Nice Guy said, please do not "trade," especially if you are -- as you said previously -- nervous about being in the market. Invest in index funds, or better yet, a target retirement fund, and just keep putting money into that fund in your IRAs and 401ks. Don't "trade." These are long term investments.

I just reread your OP and see that you think putting $17k away every year will be enough for your retirement. I think you might want to reconsider that, or at least hedge your bets while you are able to put away extra. There may be future years where you won't have an employer who offers a 401k, or you might lose your job and not be able to max it out. These are your strongest investing years for retirement -- this money will have the longest to work for you. If all you COULD do ws your 401k, fine. But if you can also do Roths, I absolutely would.

[BuckyBadger]

For what it's worth, my husband and I use a three fund "lazy" portfolio. (You can google that...) This portfolio includes Total Stock Market, Total International Stock Market, and Total Bond Market. All vanguard index funds. We used some conventional wisdom on how much you should have in stocks and how much in bonds. To determine out asset allocation we used the "your age in bonds" idea, so we are 30% bonds. Of our 70% stocks, we are 70% US and 30% International. This gives us an overall portfolio of 30% bonds, 50% US stocks, and 20% International bonds.

Now, the only reason we did this instead of just using a target retirement fund was because of the funds that were available in our 401k and 403b from through work. Target retirement funds do the exact same thing. They use Total Stock, Total International, and Total Bond index funds and they balance them as you get older to decrease your risk, so as you get closer to retirement age you will hold fewer stocks and more bonds.

There is a LOT of research that says a three or four fund portfolio gets you about 99% of what an "slice and dice" portfolio would get you, but you have to really research and spend a lot of time to slice and dice the market.

So invest your retirement in tax advantaged accounts, google three fund lazy portfolio, invest in index funds, modify your asset allocation as you head toward retirement age, and don't check your balances more than once a month if even that frequently.

[MKKShah]

A Roth is for retirement, a brokerage is not. You are comparing apples to oranges.

Mr. Nice Guy,
I am only trying to ascertain if a Roth IRA has any benefit when compared to a regular brokerage under the circumstances mentioned in the OP. The reason is that I am assuming that my 401(k) is enough for retirement.

So the question is IF I am going to clean out the Roth IRA, say in 10 years, will it be any more disadvantageous compared to a regular brokerage account?

[MKKShah]

A Roth is a no-brainer for all the reasons I posted in the other thread PLUS the fact that you can withdraw your principle at ANY TIME with NO PENALTY.

So lets say that over the next ten years you put $50,000 into your Roth. In that time, your account made some money and now you have $60,000 in the account. You can, at any age and at time and without any penalty take out that $50,000 that you put in.

Now, this is not something that most of us would recommend, since you can never replace that money due to the yearly limits and you end up losing all the compounding power that that money was exerting for you.

I promise you that there is practically NEVER a reason to open a taxable account unless you have maxed out ALL of your tax advantaged space already.

Also, to touch on what Mr Nice Guy said, please do not "trade," especially if you are -- as you said previously -- nervous about being in the market. Invest in index funds, or better yet, a target retirement fund, and just keep putting money into that fund in your IRAs and 401ks. Don't "trade." These are long term investments.

Good points. The way I now see it, the Roth IRA does not offer a whole lot of risk. Even in the scenario where I may have to clean out the entire account, it looks like the difference may be marginal. But upside of keeping the gains within the IRA until retirement are huge. No questions about that.

[MKKShah]

Also, to touch on what Mr Nice Guy said, please do not "trade," especially if you are -- as you said previously -- nervous about being in the market. Invest in index funds, or better yet, a target retirement fund, and just keep putting money into that fund in your IRAs and 401ks. Don't "trade." These are long term investments.

I am not planning to trade just yet. I have a 6 month plan to read up on investments and understand stock valuations etc. I will be trusting mutual funds in the mean time to do the work for me.

However, given the non taxable nature of the gains in the IRA, it does seem like a great place to trade (assuming one knows what he/she is doing!).

[MKKShah]

For what it's worth, my husband and I use a three fund "lazy" portfolio. (You can google that...) This portfolio includes Total Stock Market, Total International Stock Market, and Total Bond Market. All vanguard index funds. We used some conventional wisdom on how much you should have in stocks and how much in bonds. To determine out asset allocation we used the "your age in bonds" idea, so we are 30% bonds. Of our 70% stocks, we are 70% US and 30% International. This gives us an overall portfolio of 30% bonds, 50% US stocks, and 20% International bonds.

Now, the only reason we did this instead of just using a target retirement fund was because of the funds that were available in our 401k and 403b from through work. Target retirement funds do the exact same thing. They use Total Stock, Total International, and Total Bond index funds and they balance them as you get older to decrease your risk, so as you get closer to retirement age you will hold fewer stocks and more bonds.

There is a LOT of research that says a three or four fund portfolio gets you about 99% of what an "slice and dice" portfolio would get you, but you have to really research and spend a lot of time to slice and dice the market.

So invest your retirement in tax advantaged accounts, google three fund lazy portfolio, invest in index funds, modify your asset allocation as you head toward retirement age, and don't check your balances more than once a month if even that frequently.

Diversification is a great idea. I like your idea on the "your age in bonds" allocation. Sort of simplifies things. But. Given the recent bull market, a jobless recovery, and the generally poor prognosis for GDP growth in the US and other western/industrial economies, are stocks such a great idea in the near term? i.e does the downside risk outweigh any upside in the market as of today?

Should say invest 1.5 times my age in bonds based on the above?

[BuckyBadger]

Diversification is a great idea. I like your idea on the "your age in bonds" allocation. Sort of simplifies things. But. Given the recent bull market, a jobless recovery, and the generally poor prognosis for GDP growth in the US and other western/industrial economies, are stocks such a great idea in the near term? i.e does the downside risk outweigh any upside in the market as of today?

Should say invest 1.5 times my age in bonds based on the above?

Your asset allocation should be determined by your risk tolerance and nothing more. It should not be determined by how you think that the market is doing or will do. That's market timing and it never never works

A good rule of thumb is "your age in bonds" but you should adjust that up or down based on your ability to -- essentially -- ignore market fluctuations. If a bad day where your portfolio is going to lose 25% of its value will keep you up nights, then more bonds might be appropriate. The idea is that you absolutely don't want to pull out money when the market is low, so you only risk enough that you can sleep through the night on the down turns. So the question is, how tightly can you squeeze your eyes shut for the next 30 years?

The way you talk about the market worries me a bit to be quite frank... I think you may be a market timing slice and dicer at heart, and that leads to heartache pretty much 100% of the time unless your name happens to be Warren Buffett.

[disneysteve]

I will be looking towards a Roth IRA not as a retirement account, to be tapped at retirement, but something I might most likely withdraw before I am 59 and 1/2.

I am trying to understand the tax implications of a complete withdrawal from the Roth IRA and see how that fares had I invested the same money through a regular taxable brokerage account.

A Roth is for retirement, a brokerage is not. You are comparing apples to oranges.

While I typically share Mr Nice Guy's advice that retirement accounts are for retirement, that isn't always the case. For people who have other retirement assets that will meet their needs, a Roth can be a great tax shelter.

MKKShah - Don't look to withdraw everything from the Roth. Just look to potentially withdraw what you contributed and nothing more. Let the earnings stay in there until retirement age so that you avoid the penalty for early withdrawal. In that case, the Roth is definitely better than the taxable account since you avoid taxes.

That said, BuckyBadger has a good point about being absolutely sure your 401k is sufficient. How much do you earn - gross income - and what percentage of that are you putting into your 401k? Standard advice is at least 15% of gross, not counting company match, to retirement. So if you earn no more than $113,333 than the 401k might well be all that you need. In that case, I'd open the Roth with the mindset that it will be for retirement but with the knowledge parked in the back of my mind that I could withdraw some or all of my contributions later in life if necessary, as long as my 401k was performing well and growing nicely and keeping up with my expected needs in retirement.

[bjl584]

If you are certain that your 401K and other assets will be sufficient for retirement, then you could use your ROTH for supplemental tax free monthly income in retirement. Invested right, you could get your Roth account throwing several hundred or more in monthly dividends your way by the time you retire. It would all be completely tax free. A nice thing to have once retired. I would keep the Roth and make it an itegral part of your overall retirement plan.

[MKKShah]

Your asset allocation should be determined by your risk tolerance and nothing more. It should not be determined by how you think that the market is doing or will do. That's market timing and it never never works

Bucky,
I don't agree with the invest now and close your eyes approach. If you look at the last 12 years, the S&P 500 was first at 1300 mark in 1999. We are now in 2012, and it's still at 1300. Had a 30 year old in 1999 invested in the S and P 500, he would be down 31% when adjusted for inflation (for the original lump sum), and would have had a roller coster ride for a decade. The same person, had he dollar cost averaged, through, say monthly contributions, would have still only barely broken even in absolute dollar terms, and be down 20% adjusted for inflation. (The market also stayed flat between 1966 and 1981, resulting in an inflation adjusted loss of 40% for a passive investor). Maybe the last 12 years are an exception to the rule. But then again, maybe not. So I think it is increasingly important for individuals to stay vigilant about macro economic conditions and act prudently. The old "buy and hold" approach now actually, I think, means "Buy stocks, and hold on to your job, forever" Unless of course, you are able strategically assess your portfolio periodically.


Unfortunately, it looks like one may need to devote 10 hours or so per week to be vigilant if maintaining a stock portfolio on your own. So I will still be sticking to MFs, but will do what you suggested, i.e diversify across a few sectors / markets, and get into a handful of funds. When I really can devote time to my finances (and am upto speed on investing concepts), I will start investing myself. Looks like this might happen only in the 5 year time frame, and not 6 months as I mentioned before.

I have ordered a copy of the "Intelligent investor" by Benjamin Graham, to start my knowledge gaining process.

[BuckyBadger]

I disagree, but it takes all kinds to make the investment world turn. I'm a fan of this gentleman: John C. Bogle - Wikipedia, the free encyclopedia

Best of luck with your investing future.

[MKKShah]

A Roth is a no-brainer for all the reasons I posted in the other thread PLUS the fact that you can withdraw your principle at ANY TIME with NO PENALTY.

So, coming to the actual investing in a Roth. I am going to invest 20K for myself and my wife, for 2011, and 2012.
But how does this work?
Will this Roth IRA be a joint account?
My wife did not earn last year, and will not be earning anything this year either. So can I still put 10K for her in a Roth IRA?

[BuckyBadger]

incorrect information