“I’ll get back to you in a day or so”? Hardly! I have been swamped with new acquisitions, year end books, holidays, crises of all shapes and sizes, etc. I just didn’t take the time to write any blog posts. And for that I am truly sorry. It has been on my mind for at least the past three weeks, and now I am finally getting going again.
By the way… Happy New Year! It’s 2010!
First, a quick reminder about IRA changes in this new year. Certain restrictions have been removed as they relate to converting your Traditional IRA to a Roth IRA. Now, anyone with a Traditional IRA can convert it to a Roth IRA, regardless of income.
In fact, if you do the conversion in 2010, you may elect to pay the taxes due on the conversion over two years. The fun part is that neither of those two years is 2010! If you elect to pay the taxes in this manner, half of the amount converted will be treated as regular income in 2011, and the other half in 2012. If you do the conversion right now, you may not have to pay any taxes on it until April, 2012, a nice long window to set aside the needed funds.
But does it really make sense to do the conversion? Check out the “final note” at the end of this entry for someone else’s take on the complicated conversion subject. I am not going to try tackling that issue in my blog!
So, where was I? Oh, yes. We were talking last time about deciding which is better, a Roth IRA or a Traditional IRA. As of the last entry, we were talking about whether we wanted to pay the taxes on the Seed (the Contributions to the IRA) or the Crop (the Distributions at Retirement). I’d like to go through a brief analysis of the differences.
Our example from last time is that over 30 years, you have a total contribution of $150,000. Because of the great investments you’ve made, perhaps in Real Estate investments, your account has grown to $2,000,000 when you are ready to retire, which can be done with about a 14% annualized return on investment over that 30 years.
Which would you rather have, the Traditional or the Roth?
Let’s look first at a Roth IRA. If you’re in the 25% tax bracket, each year you would contribute $5,000 to the IRA and pay an additional $1,250 in taxes to the government on that money. Earning about 14% per year over the next 30 years – which, for Real Estate investors or people who know Real Estate investors, is not that difficult – your Roth IRA would grow to about $2,000,000. No taxes are taken out, and it is assumed that all the money in the account is earning 14% or so for the duration.
When it comes time to distribute the money in the account, you take out only 4% — a commonly recommended amount — of the account balance each year, while the remainder continues to grow at 14% per year. Your first year of distributions, you take out $80,000, tax free, and the rest of the account grows to $2,275,000. By year five of distributions, 4% of your account has grown to $134,000, and keeps going up each year.
Now let’s look at the Traditional IRA scenario. You contribute $5,000 to the IRA each year and earn 14% each year and get that account to $2,000,000, just like the Roth. However, instead of paying that $1,250 in taxes each year, you invest it in a taxable account that earns the same thing. (Hey, isn’t it reasonable that if you can earn 14% in the IRA, you can also earn it outside of the IRA?) The main difference is that you would have to pay taxes on the earnings from that taxable account each year.
If you’re putting that $1,250 into the taxable account each year at 14% return, in 30 years, it grows to almost $250,000, after taxes have been taken out each year at the 25% rate.
Guess what? It’s essentially a wash, even at that high rate of return.
Here’s why. When you take 4% from the Traditional IRA ($80,000 in the first year), you can pay the taxes with the earnings – not the principal – from the other, non-IRA account. You can even pay the taxes on the earnings in the non-IRA account, and still have earnings left over to grow the non-IRA account! All the rest of the money in the IRA is still growing tax free at 14%. Tax free until it’s distributed.
And it happens that way year after year, as long as you earn more than what you distribute each year.
By the way, I’m blown away by this analysis. Certainly, it’s a major simplification. And it would take enormous discipline to not only maintain the 14% return every year, but to keep from dipping into that non-IRA account and using it for other things, such as a new car, or your daughter’s wedding, or even an addition to your house.
But in its simplicity, I have learned something. I have been touting the benefits of Roth accounts for a long time, but now I’m starting to change my tune. To be sure, there are other advantages of the Roth over the Traditional, such as the inheritance differences. So the jury is still out on the subject, at least for me.
By the way, each individual’s situation is unique. There is nothing here that can be said for everyone. To help you understand what the best course of action is for your situation, you should consult with the financial planner of your choosing.
A final note. I just downloaded and read a very informative special report on whether to convert your Traditional IRA to a Roth IRA. You can get it, too, by signing up at www.RicEdelman.com. It’s called the “IRA Conversion Conundrum”. Very interesting reading if you’re considering the conversion this year. It touches on all the things that should be considered when making this important decision. (By the way, I have no business relationship with Mr. Edelman, so I get nothing for recommending that you check out this report. I just want you make sure you’re as informed as possible.)
Thank you and have a great week!
{ 2 comments… read them below or add one }
How much money do I have to pay towards the principal each month?
I received your comment today and, I’m sorry, I don’t understand the question. However, please let me try to clarify.
In the investment I’m referring to, you are earning money every month, not paying. When I refer to the principal in the post, I am talking about the amount on which you are earning interest. Once you earn the interest, that interest now becomes part of the principal on which you are earning more interest.
The concept is that in the taxable account, the interest earned in one year will be greater than the sum of 1) the taxes required on the distribution from the IRA and 2) the taxes required on the earnings from the non-IRA, taxable account.
For example, on $250,000 at 14%, you would earn $35,000. Combining that income with the $80,000 from the Distribution would give you $115,000. On that amount you may have to pay between $20,000 and $25,000 in taxes, depending on deductions you can take and because of the graduated nature of the tax system. $25,000 is less than $35,000, so you would be left with an extra $10,000 in the taxable account.
Thus the taxable account has grown (to $260,000), even though you withdrew all the money needed to pay the needed taxes. And this happens year after year.
The funny thing is that in this example, the Traditional IRA has outperformed the Roth IRA. Heck, at the end of 30 years, you now have $2,000,000 in the IRA, PLUS another $250,000 outside of the IRA. And the $250,000 is earning enough money to pay ALL the taxes and is still growing to boot!
I hope this helps. And thanks for your comment!