Re: Roth v. Traditional IRA

From: DPSnyder <DPSnyder@aol.com>
Subject: Re: Roth v. Traditional IRA
Date: Wed, 20 May 1998 14:12:59 -0400 (EDT)
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> In my case, my husband does not have a qualifying retirement account and
> we are allowed to put $2000 in his and my IRA.  In addition to that, we
> get a tax refund of $892 just for the deductions related to the IRA.  We
> can in turn invest that.
 
> None of the scenarios with the discount brokerage houses takes that tax
> advantage (which can be invested) into account.  Has anyone worked that
> out?

You are unusual in that most people don't even identify, much less invest the
tax savings of making a tax deferred contribution.

If you are truly interested in an apples to apples comparison including the
reinvestment of tax savings then you would have to do the following (IMHO):
First calculate the true cost and then calculate the after-tax benefit at
retirement.

1a)  Roth IRA  -  TRUE COSTS

- -  Contrib:    $4000 per year compounded using appropriate pre-tax earnings
rate.
- -  Tax Cost:  In order for you to contribute $4,000 after-tax to the Roth IRA,
you must have earned $892 more to pay the taxes.  So each year you contribute
it is costing you $892.  This amount would then be the $892 per year
compounded using an after-tax earnings rate.   This is the opportunity cost of
using the Roth IRA.  
- -  While the Roth IRA balance is what is available for retirement, the cost in
lost taxes and earnings should be subtracting from the Roth IRA balance at
retirement age,    to calculate the true cost over time.

1b)  Roth IRA  -  BENEFIT

- -  Calculate the monthly benefit that could be drawn using an appropriate
earnings rate
- -  No adjustment must be made for taxes since it is totally tax free at that
point.


Now let's compare this to a Traditional IRA.

I believe to compare apples to apples I need to make an observation here.  In
the above example, you earned $4,892, paid $892 in taxes, and invested $4,000.
If we start at the same place for a traditional IRA, how would the numbers
look?  You earn $4,892. invest $4000 and generate $892 in tax savings that you
can invest, plus you still have an additional $892 of income left over that
you could invest as well.  (I am ignoring in both cases the additional income
tax on the $892)

So I would contend that with a traditional IRA there is an additional $892
available to invest.  Whether or not you choose to invest it is not relevant.
So let's calculate cost & benefits:

2a)  Traditional IRA  -  TRUE COSTS    

- -  Contrib:  $4000 per year compounded using an appropriate pre-tax earnings
rate.
- -  Tax Sav:   $892 per year compounded using a after tax-rate if taxable
investment or using a before-tax rate if deferred annuity.
- -  Add'l Inv't: $892 per year compounded just like the tax savings
- -  The combined account totals would then represent the available funds to
draw on.
- -  Note that there is no tax costs to subtract because all of the funds
available were reinvested and no taxes were paid prior to retirement.

2b)  Traditional IRA  -  BENEFITS

- -  Calculate the monthly benefit that could be drawn using an appropriate
earnings rate
- -  The rate used will be differrent for each type of account:
        The Roth IRA would use a pre-tax rate (unadjusted for taxes) since no
tax is due
        The tax Savings Account and the Add'l Inv't Account would either use a
pre-tax
             rate if the money has already been taxed or an after-tax rate if
the money
             has not yet been taxed (such as annuity)

At this point I would compare the costs associated with generating the after-
tax retirement benefit and decide which way was the most cost and tax eficient
way for me to provide myself with retirement income.  Let me say I also
believe in diversification and would probably look at trying to incorporate
both Tax-deferred and Tax-free accounts into my plan.

Hope this is helpful and not to technical.

Dan Snyder



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