Wednesday, August 20, 2008

Carrots and Sticks

" If the people don't want to come out to the ballpark, nobody's going to stop them "
- Yogi Berra

You may be contemplating how best to allocate your retirement savings contributions among the many choices available. You have probably heard about the Roth IRA and its cousin, the Roth 401k. Let’s see if we can shed some light on the issues involved in making the choice of a Traditional IRA or a Roth IRA. Along the way we’ll do the same for the Traditional 401k and the Roth 401k.

Let’s assume that you want to save for retirement and that you can afford to do so.

So where do you put your money? We must distinguish here between the conduit by which you save and the actual investment of the funds. These are two different things. Today we are talking about the conduit by which you save and have little interest in the actual investment of the funds.

The conduit by which you save is the account into which you make your deposit – “contribution” in retirement account parlance. For example, an IRA (Individual Retirement Account) is not an investment in and of itself, but a conduit through which one can invest. I’ve had many conversations over the years in which people have told me they have an IRA but when I query them about what it’s invested in, they revert to insisting they have an IRA, believing the IRA itself is an investment. So, an IRA (or other retirement savings conduit) is not an investment but is a means by which one can invest. An analogy may be helpful: think of an IRA (or other account type) as a garage and the investment as your car that you park in the garage.

So which type of retirement conduit should you have? Like a lot of answers in the financial world, “it depends”, so let’s do a little compare and contrast.

#1 Caveat: All information here is based on U.S. tax laws as they exist in 2008.

#1 Carrot: ALL retirement accounts offer tax deferral on account earnings. No income taxes are due during what is called the "accumulation phase" - the period during which you are making contributions.

#1 Stick: You will pay income taxes on some or all of your retirement account balance at some point in time (either when the funds go in or when the funds come out).

Traditional IRA (tax deductible)
Carrot: Contributions made to a Traditional IRA may be tax deductible. This means for those who qualify, the amount contributed is deducted (line 32 of the IRS Form 1040) from “total income”. The annual contribution limit for those under age 50 is $5,000 ($6,000 if you are 50 or older). So if you contribute the full $5,000 and qualify to deduct the entire amount, then your income is reduced by the $5,000 ($6,000) contributed to the IRA. You have reduced your income tax by the amount of the IRA contribution times your marginal tax bracket. Assume your marginal tax bracket is 28%. This means that the last dollar of income you receive each year is taxed at 28% (not accounting for special treatment for capital gains, dividends, etc). This works in reverse when making a tax deductible IRA contribution. $5,000 times 28% = $1,400 off your tax bill for the year. Magic? No, just math. The bottom line is that putting away $5,000 only cost you $5,000. Without the deduction, you would have to earn $6,944, pay 28% in income taxes to bring home the $5,000 to put in the account.

Stick: All distributions from a Traditional IRA (with all contributions deducted) are taxed as ordinary income (no capital gains or other special treatment). An additional 10% penalty tax is added if the account owner is <59 http://www.irs.gov/ – look for Publication 590.

Roth IRA (non-deductible)
Stick: Contributions made to a Roth IRA are not tax deductible. To put $5,000 in a Roth IRA account, you have to earn $6,944 then pay 28% income taxes to bring home the $5,000 to put in the account.

Carrot: All qualifying distributions from a Roth IRA are not taxed. This means no income taxes are due on the money earned by your contributions. A “qualifying distribution” is one that occurs after the account owner is 59 ½ AND the account has been open for five years. HINT: If you are eligible, open a Roth IRA now to get the five year clock started – especially if you are >50.

Income limitations apply - check the eligibility rules for opening a Roth IRA at http://www.irs.gov/ – look for Publication 590.

Traditional 401k (tax deductible)
Carrot: Contributions made to a Traditional 401k are tax deductible. The annual contribution limit is $15,500 ($20,500 if 50 or older). Your employer may match a portion of your contribution. The employer contribution is not taxed to you at the time it is made. The same tax accounting applies as for a Traditional IRA: since the contribution is tax deductible, it only costs you $15,500 to make a $15,500 contribution.

Stick: All distributions from a Traditional 401k (including employer contributions and related earnings) are taxed as ordinary income.

Roth 401k (non deductible)
Stick: Contributions made to a Roth 401k are not tax deductible. Contribution limits are the same as for the deductible 401k and the rules are written such that total 401k deferrals are limited to $15,500 (or $20,500) so you can contribute to both types of 401ks at the same time, but the total contribution allowed doesn’t increase. To put $15,500 in a Roth 401k account, you have to earn $21,527 then pay 28% income taxes to bring home the $15,500 to put in the account.

Carrot: Qualifying distributions of your contributions plus earnings from a Roth 401k are not taxed. Employer contributions are not taxed to you when they are made.

ALERT: Employer contributions to a Roth 401k (plus related earnings) are accounted for separately and are taxed as ordinary income upon distribution. This is so for the simple reason that the employer’s contribution is a tax-deductible expense to the employer – since the employer contribution is deducted on the way in, it must be taxed on the way out.

So now that we’ve covered the basic differences between the retirement accounts available to most people, the question occurring to you is probably something like this: If I have a choice, what should I choose? We’ll cover that topic in our next post.

Questions? kimm@sweetwaterinv.com

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