Why Would I Want to Contribute to an IRA?

The answer is, if you're confident you can make capital gains, then usually you want to place those investments outside of any retirement accounts.

But place into the retirement count investments that produce regular taxable income, such as taxable bonds, as well as some other categories like gold.

If you're a pure-play stock-market (or private equity) investor predicting large capital gains with a short horizon, then retirement accounts don't buy you much. But they will have benefits when you shift to something more conservative.

Steve

Or, maybe somewhere in between! ;-)

But, you have to ask yourself, what will capital gains rates be in retirement? What will your tax bracket be in retirement? Does your state even have a special rate for capital gains (California does not).

The IRA (and 401k) are based on the simple concept that your marginal ordinary tax rate in retirement (when you take distributions) will be significantly lower than your marginal ordinary tax rate during your peak earning years. Using today's rates, a drop from 25% to 15% tax bracket is quite significant.

If your rate will *not* be lower in retirement, then you're right, a traditional IRA is not much of an advantage.

Think of it as a form of diversification -- have some investment in tax-deferred accounts, some in regular tax accounts, then hopefully whichever way the tax law blows, you'll get the usual benefits of diversification.

The other benefit, for some, is the "forced savings" aspect of retirement accounts. They're structured to strongly discourage you from touching the money once you set it aside. Kind of like what home equity used to be, before the banks encouraged people to turn their houses into ATM's.

Don't know where you get "doubling", see above. You have hit on another key feature, though: if you have the discipline to also invest the amount you save in taxes each year, then you'll maximize the benefit. For example, put $4K in your Trad IRA/401k, and also put the $1K tax savings (at 25% bracket) in a long-term investment.

It's not hard to work up a spreadsheet to run some scenarios. As I just mentioned, to compare apples-to-apples, don't forget to include the actual tax dollars that were deferred in your calculations.

You should definitely look into the advantages of contributing (or converting) to Roth IRA in 2010 when the income limits go away. Sounds like you don't have anything to convert. Some people have been making non-deductible contributions to Trad. IRA for the last several years in anticipation of converting when the limits went away.

-Mark Bole

One more thing to point out: If you're lucky enough to not qualify for a deductible IRA, but not quite lucky enough to be disqualified for a Roth IRA, there are clear advantages to investing in the latter: all your gains will be tax-free, so I don't see any downside. Conversion from conventional to Roth IRA are a more complicated matter.

So, what might be the advantages -- if any -- of a 2010 IRA to Roth conversion for a couple well into retirement, both in the mandatory minimum distribution age bracket, with essentially all their net worth except residence in tax-deferred IRAs, and with IRA minimum distribution plus some help from Social Security about matching their annual living costs?

One spouse says taxes are sure to go up with time in coming years; we should convert some of our IRA to Roth in 2010.

Other spouse says, true about the benefit if taxes rise in the future, but only if the IRAs are terminated at death; and what we hope to do is have any funds remaining in the IRAs at second death roll over into retirement IRAs for children, which means NO tax hit at that point, and substantially extended payout period.

In addition, there are NO net benefits from rolling over now or ever if taxes stay stable and IRA and Roth funds both earn at same average rate (which seems the sensible view); and since our living costs aren't likely to go down (maybe will go up if medical costs hit), we'll keep pulling money out of IRA + Roth at about the same rate, with or without rollover.

I'll be trying some spreadsheets on all this myself.

One factor arguing against Roth is if you believe something like a national sales tax is in the cards. Roth conversions are taxed at conversion, and with a future sales tax you are than taxed again when you withdraw the funds and spend them. In some scenarios there would be a high future sales tax, but lower income tax; these scenarios argue against Roth.

Steve

A common strategy is to convert just enough to take you up to the top of your current tax bracket for the current year.

Non-spouse beneficiaries have to start taking out at least some money right away, unless they wait five years and take it all out.

You get the joy of telling your beneficiaries how much money you're leaving them, and the tax pro gets the pain of telling them how much it'll be after taxes. ;-)

Suppose you contemplate the conversion of X dollars. You've got

• Y = today's lump sum tax payment on X vs.

• net present value (NPV) of future tax payments on X, minus the NPV of after-tax gains on Y

But don't forget you also have

• zero tax payment on the future *gains* on X vs.

• NPV of future tax payments on the future gains on X.

Having a timeline that encompasses beneficiaries and their respective tax rates just makes it all the more complicated.

and since our living costs aren't

But it's nice to have the option not to take an RMD if you don't need it. I don't know the dollar value of that option. An article that has been posted here before, it's not light reading but is pretty thorough, given that it was written in 2007:

Try that, and also look for any out there already, I suspect there must be some.

-Mark Bole

On Aug 8, 10:24 pm, Doug wrote: [snip]

The variable quantities to look at are your average periodic rate of return on investment, the number of periods, the relative tax rates. Of these, the rate of return is really the most significant. Assuming less than 10 periods in ten years and thus the 15% cap gains rate, your break-even is at around 26%.

R = rate of return e.g. 20% P = periods (or number of turnovers) T = (1- tax rate)

I'm a little too lazy to do the complete equating formula :-) but Capital x (1+R)^P = gross IRA return x T = net IRA return Capital x (1+(RxT))^P - net outside IRA

Higher than 26%, and more frequent trades than one per year (>10 periods), you're better off trading in the IRA - especially since your gains outside the IRA would be subject to 35% or higher tax rates as short-term gains. DHI was available below $5 in 2000 - in five years it peaked at $40. I sold around $15 :-( but you see the full potential gain of 50% average annualized would have remained untaxed until withdrawal. The interest on it is on the untaxed amount.

(The equating formula involves the reduced return resulting from the periodic taxation, e.g. at what point does a 26% rate of return taxed once at 35% equate to a 26% return periodically reduced by 15%.) (I think I got my math right in this - no guarantees, OK? :-)

Thing is, if you can reasonably secure 26% returns (not impossible:-) then you want ALL your capital so employed, both in and out of your IRA, and the whole exercise is moot. The psychological trap to avoid is letting the taxes wag the dog of sound investment planning. It's going to be taxed, regardless of one's opinions. An IRA was not designed specifically as a tax shelter - it is a 'savings' account. But if you have short-term opportunities, an IRA can be useful.

Respectfully disagree, that is exactly what an IRA was designed for. Employee Retirement Income Security Act of 1974 (ERISA) created IRA's as a form of do-it-yourself pension for those not already covered by traditional pensions -- which is why there are restrictions based on having earned income and whether or not you are already covered by an employer-sponsored pension, whether defined contribution or defined benefit.

Wikipedia[*] page on "tax shelter" prominently lists IRA's as a form of government-sponsored tax shelter designed to encourage certain behavior. The behavior was based on pensions, not "short-term opportunities".

[*]Yes, I know someone will immediately bash Wikipedia, but it is not garbage and does carry some meaningful weight, probably at least as much as some of what gets posted here. ;-)

-Mark Bole

Capital gains were taxed at the same rate as income before 1977 and between 1986 and 1994. Who knows what the tax rates will be in the future.

Qualified retirement plans are protected from several kinds of court actions. These include bankruptcy and civil judgements. Exceptions include not paying taxes, child support and divorce splitting. You never know when you'll be in accident (by defintion undpredictable) and up against crafty lawyers. I've been that situation.

Yes, they do: short-horizon is short term capital gains, with high taxes.

If that's long-term capital gains, there's much less in the way of benefits.

Seth

I should clarify by "short horizon" I meant under 5 years or so. The significant tax advantage of retirement plans is over the longer term.

Steve

Tax deferral saves you money, this is a little understood point. You may be better off paying a higher rate of tax when you withdraw money than a lower rate every year.