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After-tax IRA vs. taxable account

You could estimate the tax efficiency of your taxable investments to figure this out. You could do this one of two (or many) ways.

First, you could estimate your future effective tax rate for your taxable investments. I do this by determining the amount of tax I've paid over the years on my investments at my marginal rates (with the addition of estimated taxes due on unrealized capital gains) and dividing that by my investment gains (including unrealized gains). This approach is better than just using capital gains rates each year because it gives credit to some extent for trading strategies that reduce taxes and also it reflects actual durations that I hold assets. If you just used capital gains rates, then you would have to make assumptions about how often you sell assets (you flip everything every year, you hold everything until the end, or something in between), and how much of your return is dividends. This approach is time-invariant, but suffers from not taking into account the amount of earnings that your tax payments could have earned had they been invested instead of being paid to Uncle Sugar.

Alternatively, you could estimate the effect of taxes on your returns. First, estimate the returns on your investments before taxes (I use the XIRR function in Excel for this - be sure to include flows for selling your entire account). Then estimate the returns while including the cash flows from taxes paid (again I use the XIRR function in Excel, but I include cash flows for taxes this time). Dividing one by the other will give your tax efficiency over the period. The advantage here is that you include the time value of tax payments, but the result you're looking for is no longer time-invariant, you would need to look to see if there is a break-even point within your investing time horizon where the taxable account becomes less effective than the taxable IRA.

Of course, these are just estimates, tax rates will change in the future, favorable capital gains tax treatment may go away, and your investment style will fluctuate. And of course, you may want to use a taxable IRA just so that you can roll it into a Roth in 2010. But this will give you a basis for playing around with the numbers. In my case, I've decided that taxable IRAs are not for me, I use taxable accounts instead, given the tax efficiencies that I have so far achieved.

-Will

Reply to
Will Trice
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Don't forget the AMT! I agree Sandra that it is highly unlikely that the whole "Roth format" will be repealed, but recent trends have shown that the IRS is using the AMT to do their dirty work. By modifying what is an allowable deduction under AMT, they can alter the ability for individuals to take deductions without actually eliminating the deduction.

Everyone knows to diversify risk: they shout it from the rooftops when speaking about investments. Why is it that those same people ignore their mantra when it comes to taxes?

Reply to
kastnna

You aren't starting on an even playing field with those figures. If you put $4000 in a pre-tax IRA you get 1000 back come tax time so you only have $3000 invested but it compounds at the same rate as a $4000 investment in an after tax roth. Thumper

Reply to
Thumper

Right -- which shows that having $4,000 in a Roth is not the same as having $4000 in a traditional IRA. But I never said it was.

Let's compare two scenarios. In each one, you start out with $4,000 to invest.

1) You put $4,000 into a traditional IRA.

2) You pay 25% taxes on the $4,000, leaving you with $3,000, and you put the $3,000 into a Roth IRA.

Because the starting point is the same in either of these scnenarios, I claim that they are of equal worth.

Now, suppose you wait a while, your investment quadruples, and you want to withdraw it.

In scenario 1, you have $16,000. When you withdraw it, you have to pay 25% in tax, leaving you with $12,000.

In scenario 2, you have $12,000. You can withdraw it without paying any additional tax.

So the two scenarios are still of equal worth.

To recap: If you are in the 25% tax rate, then having X dollars in a traditional IRA is worth as much as having X*(1-25%) in a Roth IRA.

Of course, if tax rates change, it changes the relative worth of the alternatives. But assuming a constant tax rate of 25%, I can see no reason to prefer $3000 in a Roth over $4,000 in a traditional IRA or vice versa.

Now, it *is* true that even if tax rates don't change, the fact that the dollar contribution limits are the same for both kinds of IRA makes a Roth more desirable, as you can use it to shelter more income. But that issue isn't part of this discussion.

Reply to
Andrew Koenig

In my case, I have a tax paid basis (about 20%) in my standard IRA, so I gain a little from converting. And, since I can pay the conversion taxes out of regular savings, I can increase the effect amount of tax free retirement account money.

-- Ron

Reply to
Ron Peterson

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