401(k) IRA matrix

401(k) IRA matrix

This is a comparison between 401(k),Roth 401(k), and Traditional Individual Retirement Account and Roth Individual Retirement Account accounts.


=Comparison [IRS Publication 4530 [http://www.irs.gov/pub/irs-pdf/p4530.pdf] ] [IRS Retirement Article [http://www.irs.gov/retirement/article/0,,id=156204,00.html] ] [IRS Roth Chart [http://www.irs.gov/pub/irs-tege/roth_chart.pdf] ] =

IRA: Roth vs. Traditional

The decision between choosing a Roth IRA vs. a Traditional IRA depends mostly on whether you are likely to be in a higher tax bracket in the future (in which case a Roth IRA is better) or a lower tax bracket in the future (in which case a conventional IRA is better). Roth IRAs also have a bit more flexibility in terms of early withdrawal. If your tax bracket does not change while you are working vs. when you retire, you will end up with the same amount of money in a Roth IRA as a conventional IRA for a donation less than the maximum allowable. If you save the maximum allowable amount in an IRA, "and you stay in the same tax bracket", there is a tax advantage to the Roth-IRA. For instance, in 2007 the maximum traditional IRA for a 40 year old was $4000. Any additional investment above that would have to go into a different account. The following example illustrates the tax consequences: :"Roth IRA." A $4000 contribution to a Roth-IRA growing at a constant rate of 10% will, in 25 years, grow to 4000 * 1.125 = $43,338.82. Because this $4000 contribution is not tax-deductible, the contribution plus the tax will cost 4000 / (1-.25) = $5333.33 in the year of contribution (i.e. the taxes on $5333.33 earned will be $1333.33, leaving $4000 to invest). :"Traditional IRA." $4000 contributions to traditional IRA will grow to $43,338.82 in 25 years using the same assumptions and calculations above. The tax on this amount will be 25% * 43,338.82 = $10,834.71, leaving 43,338.82 - 10,834.71 = $32,504.12 from the IRA account. However, the investor will have additional tax savings of 4000 * 0.25 = $1000.00 to invest in a "naked" (i.e. taxable) account. (Equivalently, out of earned amount of 5333.33, 4000 will go towards IRA contribution, and remaining 1333.33 will be taxed at 25% with $1000.00 left to invest.) With earnings taxed every year, this $1000 amount will grow to 1000 * (1 + .1 * [1-.25] )25 = $6,098.34. This implies a total, after-tax amount of 32,504.12 + 6,098.34 = $38,602.46 (roughly 12% worse than Roth IRA with our assumptions).

:"Explanation." The Roth IRA is better because we are effectively making use of $5333.33 for Roth IRA tax advantages but are only able to use $4000 for Traditional IRA tax advantages.

:If total $5333.33 amount "were" able to grow in a tax-deferred Traditional IRA account, then the additional $1333.33 would grow to 1333.33 * 1.125 = $14,446.27, and if taxed at 25% upon withdrawal would imply 14,446.27 * .25 = $3611.57 in taxes, leaving 14,446.27 - 3611.57 = $10,834.71. Adding this to the $32,504.12 amount from the Traditional IRA savings equals 32,504.12 + 10,834.71 = $43,338.82, just like in the Roth IRA.

Note that the same applies to choosing whether to contribute "the same amount" to regular or Roth 401(k) - either because you only want to contribute up to the employer match, or because you want to contribute up to the maximum amount. If, on the other hand, you are able and willing to contribute extra tax savings to Traditional IRA / 401(k), tax advantages of Roth IRA / 401(k) over Traditional IRA / 401(k) highlighted above will no longer apply.

References

External links

* [http://www.banksite.com/calc/rothira Roth vs. Traditional IRA Calculator]
* [http://www.theusefulinfo.com/finance/compare4R.html 401(k) vs Roth IRA]
* [http://www.fairmark.com/rothira/decision.htm Decision factors]
* [http://www.rothira-advisor.com/rothvalue.htm The Value of a Roth in an Estate]
* [http://retirementdictionary.com/401-l-plan.htm RetirementDictionary Definition]


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