But if you contribute the max to a 401-K whether it’s traditional or Roth, you can still invest in a traditional or Roth outside of that.
Roth vs. traditional IRA: We’ve always encouraged our children to contribute to a Roth first (rather than traditional IRA). However, this year, they received a gift in the form of appreciated assets which were then sold. Since their income is just over the 15% bracket, they are taxed on a proportion of the capital gains. By contributing to a traditional IRA, they lower their taxes – including the amount due on the capital gains. Basically this results in an automatic 15% return. Does this logic sound right? If so, for this year, it makes sense to contribute to the traditional first?
Told S the info I’ve gleamed from here. Told him he had to increase his 401k and needed to talk to his benefits coordinator about the ROTH. He was going to change what he was contributing while we were talking but couldn’t get into the site. It sounded like he was going to figure that out tomorrow. I’m feeling good about our conversation.
He changed his withholding while we were talking so maybe next year he will finally have it figured out and won’t have to pay too much. He’s not worried though, but it’s nice not to owe.
He won’t be buying a house until fall when his lease is up.
This has been very informative. thanks.
If he contributes to a traditional IRA (instead of a Roth IRA) for 2014 prior to April 15, couldn’t that reduce his tax due for 2014? Then at some point in the future, he could convert that traditional IRA to a Roth so the earnings are tax-free (although he’d have to pay some tax during the coversion). Maybe someone can check me on this.
Although it stinks to owe a large amount on 4/15, it is actually theoretically better than overpaying since you could theoretically have invested those funds instead of handing them over sooner to the IRS. It hardly ever feels better, though.
Yes he could but why not pay it now and have all future earnings tax free. What would be the point in paying the tax later on both the initial contribution plus the earnings?
I thought gifts received were not considered taxable income.
I assume the gift is appreciated stocks? Once the stocks are sold by the recipient, gains are realized and taxed according to the recipient’s tax bracket. If the stocks are not sold, there is no tax.
If gift is cash (assuming the cash is after tax) then there is no tax.
Many people in higher tax bracket gift appreciated assets to a lower bracket recipient and if the appreciated assets are sold by the recipient, less tax is levied and more net gain is realized.
Generally, gifted stock has carryover basis.
Njres - if someone gifts you an asset such as a house or stock, their cost basis carries over to you. When you sell th asset, you pay taxes on the gain. For instance, if I give you a stock I purchased for $1000 & you sell if for $5000, you will have to recognize a gain of $4000. If I sold the stock and gave you the $5000, you would have no tax liability, but I would have to report the gain.
Here’s a good calculator to show the kids. Sending it to my son.
http://www.bankrate.com/calculators/retirement/401-k-or-roth-ira-calculator.aspx
I assume most will not invest their tax savings each year for the traditional .
@Manhattanboro - Regarding @cincygal #7 post, some of the thoughts behind the recommendations are:
- Virtually all corporate matches are paid and contributed to your plan each paycheck. Only a handful of companies lump sum their matches. So, if your company matches the first 5% of your contributions (or whatever it is), sign-up for at least 5%. That way you pick up the match and maximize take home pay to make your Roth contribution
- Hopefully at somepoint in your career, you will earn too much to make Roth IRA contributions, so you need to make these contributions while you can! So, the next goal is contribute your maximum $5,000 into a Roth. Since these dollars are after tax, you don't want to overwithhold for your 401(k) (See item#1) so these contribtutions are maximized. This tends to be a lump sum, or a series of lump sums, since Roth IRA tend to be owned directly by the participant (through a broker or mutual fund family) rather than an employer. Please note that some employers MAY offer Roth 401(k)'s that can be withheld from your paycheck.
- Many advisors also suggest diversifying your retirement assets between pre-tax and Roth to mitigate the effect of future tax policy changes. That is why having 401(k)s and Roths are both good ideas. It is such a good idea many high income taxpayers are voluntarily paying tax on there pre-tax IRAs and converting them to Roths just to achieve that diversification!
- If you can do the math and budgeting, and know that your budget can handle say an 8% 401k contribution and still make a Roth contribution, there is typically no need to change your withholding frequently. However, if you need help to get to that point, this is a strategy to help get you there.
Here is an easy illustration to show kids who are working at a young age that they should contribute NOW to an IRA or Roth
I pulled this out of CNN Money but you can find similar examples from other places.
"Here’s an example of what a big difference starting young can make. Say you start at age 25, and put aside $3,000 a year in a tax-deferred retirement account for 10 years - and then you stop saving - completely. By the time you reach 65, your $30,000 investment will have grown to more than $472,000, (assuming an 8% annual return), even though you didn’t contribute a dime beyond age 35.
Now let’s say you put off saving until you turn 35, and then save $3,000 a year for 30 years. By the time you reach 65, you will have set aside $90,000 of your own money, but it will grow to only about $367,000, assuming the same 8% annual return. That’s a huge difference."
I left a copy of that on my kitchen counter …within a week daughters boyfriend put $5000 in a Roth…too funny.
the above is from:
http://money.cnn.com/retirement/guide/basics_basics.moneymag/
I saw that same article when mine were in their teens and it had the same effect. Now consider the difference between putting that $30,000 in a traditional IRA vs a Roth. Had you paid tax on it at 15% or even 28%, the $472,000 will be tax free. Whereas if you put it in a traditional and saved the tax, when you retire you will be paying tax on that same $472,000 at an ordinary tax rate. Even if you plan on being in a lower tax rate when you retire it is beneficial to have paid it when young. And most people who are that financially prudent in their youth will be paying a high enough tax rate when they retire.
Also, if you have always put your contributions into a Roth, when you get to be high income, you cannot contribute directly, but you CAN contribute to a traditional IRA and immediately convert to a Roth tax free. Which essentially means you can do it forever even when you start to make too much.
That’s not even considering the other advantages of a Roth: no required distributions when 70.5 and leaving it to your heirs tax free. Not being required to take distributions from your Roth when you retire also keeps your tax bracket lower.
I advise as many people as I can that if they are young, they might even consider converting their IRAs to a Roth and paying the tax.
The problem with this example is that it assumes the cost of putting $30k into a tIRA is the same as the cost of putting $30k into a Roth. It isn’t. For example, let’s say you have 30k in pre-tax income to invest and you’re in the 15% tax bracket. If you choose to fund a tIRA, the $30k is subject to taxes, and you only end up putting put $25,500 into the tIRA (you would need $35,295 in pre-tax income to put $30k into a tIRA). Take that $25,550 and assume x% average rate of return over y years. You’ll get z value. Now take $30k and assume the same average rate of return over the same period of time. Multiply that figure by .85 to account for taxes upon withdrawal, and you get z. If you have the same tax rate at the time of contribution and withdrawal, there will be no difference between the tIRA and a Roth. The Roth is only advantageous if your tax rate is higher when you make your withdrawals.
I agree with you that young people, especially young professionals, should use a Roth IRA/401k/457 instead of their traditional equivalent, but for different reasons relating to estate planning.
There are lots of web-based calculators like the one linked above in post #29. A number of them can be found here http://www.bankrate.com/calculators/index-of-retirement-calculators.aspx
Playing around with the calculators will give a good demonstration of what posters above have written.
While it would be ideal to make a full 2015 Roth IRA in early 2015 vs. late 2015 or even early 2016, here is a piece of Roth IRA investment advice that our adviser gave to my DD when she first started working: save money every paycheck with the intent that it will go into a Roth IRA. Then at the end of the year, put the money into the Roth IRA. While it won’t be invested as long then, it can help a young worker/saver to figure out a working budget. No one should be pulling money out of a Roth for a near-term expense.
One limitation most online calculators have is that they don’t account for the change in contribution limit once you turn 50. If you plan on maxing out your IRA/401k/457 contributions each year and want a more accurate projection of your retirement savings, look for a calculator set up as an Xcel spreadsheet. The increased contributions from 50 to 70 can make a big difference.
Alexander’s post doesn’t make sense to me. Maybe mathematically, but in real life you have the decision each year whether to put $5,500 in a traditional or a Roth. So if the OP’s son who is obviously young, puts it in a traditional to save the tax on it at 15% (or less, I don’t know his tax bracket) he’s still putting in the $5,500. If it grows for 30-40 years it will be way better to have it grow tax free.
Also, it’s true that those spreadsheets don’t account for the rise at 50. But they also don’t know what it will be then. When my kids started putting money into a Roth the maximum was only $2,000. And they are only in their early 30s.
My uncle converted his entire IRA into a Roth in 2010 when the market was way down. He took one large hit but has been extremely happy ever since. Has already made back the tax he paid. Meanwhile, he has no RMD which makes his tax bracket smaller now and since most of his income is in capital gains, pays very little tax. Had he still had it in an IRA his tax bill would be huge.
I don’t get the math that Alexander demonstrated. Say you contribute $5,000 in a Roth ira for ten years. So that is $50,000 of income that was taxed at the tax rate in effect each year. But in those ten years interest also gets added do the final balance is more than $50,000. So how can one say that as long as your tax rate is the same you will end up paying the same amount of tax?
@3bm103
I agree that a fully funded Roth will give you more spendable cash in retirement that a fully funded traditional IRA. The point I was trying to make, perhaps poorly, is that comparing $5,500/year in a Roth with $5,500/year in a traditional IRA isn’t a fair comparison because a person who fully funds a Roth has actually spent $6,325 to do so (assuming a 15% tax rate), whereas the person who fully funds a traditional IRA only spends $5,500. The person who funded the traditional IRA has an additional $825/year in pre-tax income to invest. If you’re going to compare the relative worth of funding a Roth versus a traditional IRA, you have to account for that additional $825/year and the compound interest it would earn if it was invested.
So let’s run the numbers assuming $5,500/year contributions for 10 years with a 10% average rate of return and a tax rate of 15%. At the end of 10 years, the Roth would have $96,421.42 in after-tax funds. The traditional IRA would also include $96,421.42, but it would be subject to 15% tax, leaving you with $81,958.21 in after-tax funds.
But the person funding the traditional IRA also has $825/year in pre-tax funds to invest. This extra money is subject to 15% tax, so only $701.25/year of it gets invested (and let’s assume it’s invested in a Roth). That $701.25/year earns the same 10% average rate of return over the next 10 years, giving you $12,293.73. So 10 years down the road, the person funding the traditional IRA has $94,251.94 in after-tax funds.
So my comment at #33 was a bit of an overstatement. It’s not a complete wash. In this situation, the person funding the Roth ended up with $96,421.42 compared to $94,251.94 for the person who funded the traditional IRA. But the difference is minimal, much smaller than most people assume when they talk about the advantage of tax free growth in a Roth.
Another important tax consideration is the fact that funding a traditional IRA/401k/457 allows you to reduce your AGI. For some people, this means qualifying for deductions or exemptions they would otherwise be phased out of. The decision between Roth and traditional retirement vehicles isn’t as simple and clear-cut as conventional wisdom makes it seem.
I apologize for the lengthy post. I’m not trying to nit-pick or disagree for the sake of arguing. This is just a topic that’s very much on my mind these days. My wife and I have always been big savers/investors, but we never gave much thought to how or where we should invest the money until we became parents last year. I guess I’m finally getting some use out of those econ and finance classes I took in undergrad. 
If we are talking about a young person who is just starting out in 15% tax bracket he should fund Roth after investing into pre-tax 401K up to the employer match. Roth allows to take money out, fund 10K for the first time home purchase, pay for the last year of child’s college, etc. When tax bracket becomes 25% the strategy can be revisited. If deductions/tax credits are on the line then strategy can be revisited again. It seems you should have both types of retirement accounts for maximum flexibility.