29
May
Posted in Great Debates, retirement by Roger, the Amateur Financier |
Welcome once again to the little corner of the blog where we discuss some of the greatest arguments in the personal finance world. Today, we’ll discuss which is better when planning for your retirement, a traditional IRA or a Roth IRA. (There are also traditional and Roth flavors of 401(k)s, as well, but since that choice will be made by your company and its human resources department, you’ll have less control over which variety you will have.)
The big difference between the two types of IRAs is when the the money you invest in them is taxed. In traditional IRAs, the money you invest is taken from your taxable income, allowing you pay fewer taxes now, but the withdrawals when you retire are taxed at your regular tax rate. Roth IRAs are funded with after-tax money and the withdrawals are tax-free. The decision then becomes when you want to be taxed, now or when you retire.
Therefore, there’s a simple way to determine which type of IRA will be better for you: hop into your time machine, travel forward to the time you retire, and see what tax rates you will be paying. If the rates are higher in the future than they are now, you’ll do best financially with a Roth; if the rates are lower (or if the Fair Tax has been enacted), than a traditional IRA is the way to go. Then, come back to the present and open that style of IRA; easy as pie!
What’s that? You don’t have a time machine? That complicates matters a bit. You can still choose the style of IRA you open based on what you think the future will hold for tax rates. Personally, given the rising national debt and rather low current tax rates, I would imagine that tax rates are only going to rise in the future (although, again, the Fair Tax or other non-income taxes could drastically change the tax landscape), making Roth accounts more attractive. Some other questions to ask yourself:
Will I need more or less money in retirement? – As a consequence of our graduated tax system, the less income you have, the lower taxes you pay as a percentage of your income. Thus, since different IRAs allow you to be taxed at different times, you can attempt to determine how much money you will need to spend in retirement. If you intend to cut down your spending when you retire, even just to the 70-80% of your final income that many experts say that you need, traditional IRAs should be beneficial; if you intend to maintain or increase your current level of spending, a Roth IRA will help you dodge the tax burden.
Do you want to lock in your tax rate? – One of the biggest advantages of a Roth is that you know what tax rate you are paying now (or at least, should be able to figure it out), and therefore know exactly what you are paying in taxes. As we’ve already discussed, though, tax rates in the future are a big unknown. If you prefer to pay your current tax rate and not have to worry about tax increases in the future, a Roth provides you with that opportunity. On the other hand, if you are currently in a high tax bracket, taking a tax break now for your traditional IRA may make the most sense.
(If your taxable income is high enough, you may not even have the option of using a Roth. For single filers, you can put in the maximum ($5000) if you earn less than $105,000 in 2009, with partial contributions allowed up to an income of $120,000; married couples filing jointly can donate up the max if they earn less than $166,000, and partial donations up to $176,000. A complete matrix comparing income limits and other factors affecting traditional versus Roth IRAs and 401(k)s can be found here.)
Am I diversified? – Diversification isn’t just about holding a variety of investments, it also involves ensuring that your portfolio is prepared for whatever the tax rates do in the future. If you have a traditional 401(k) at your work place, having a Roth IRA to help in case of rising taxes is a good way to diversify. Similarly, if you are one of the lucky ones who has a Roth 401(k), having a traditional IRA can help to lower you current tax burden and help to minimize the taxes you will pay overall.
These questions, as well as your thoughts about how taxes will change in the future, will help you to decide which type of IRA will be best for you. As is frequently the case, there is no easy answer to which type of account is better that applies to everyone equally, but hopefully, asking yourself questions about your tax rate, future spending, and the types of other accounts you hold will help you to make some good decisions. Happy retirement planning!
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28
May
Posted in Thoughtful Thursday by Roger, the Amateur Financier |
This morning, I had a little bit of a scare, finding that my blog was down when I went to update it this morning. It turned out that there was maintenance being done on the server, which is what shut down my blog. After a brief period of panic, I settled in for a good day’s sleep (one of the advantages of being nocturnal, I suppose), and when I woke up, I discovered that my beloved blog was back up. So, yay for that.
This whole experience has made me realize that I need to learn more about computer programming and similar technical issues. I’ve been learning slowly, but if I hope to make my blog into a regular source of income, I will need to be able to maintain my own blog without requiring assistance. Any suggestions as to where I can learn more about the fine art of blogging?
Some of the blog entries that made me think this week include:
The Advantages and Disadvantages of Going to Community College – Studenomics covers some of the advantages (smaller classes, less expensive tuition) and disadvantages (less challenge, less creditability) of starting your college career in community college. He raises some interesting points; if I were approaching my college years and didn’t have the financial backing I was able to atain at my univesity, I would consider the possibility of community college long and hard. It’s not a bad place to start (but probably not finish) your higher educational career.
Using Financial Aid to Graduate Debt Free – Keeping on the subject of decreasing your college education costs, My Life ROI covers some of the types of financial aid available to college student. Given the rapidly rising cost of higher education (at least if you’re not in a community college), it’s good to know more about ways to defray some of your out of pocket expenses.
Parents Bamboozled by FreeCreditReport.com – Stephanie of Poorer Than You recalls a story where her mother and step-mother used a site (which I have no intention of repeating or linking to here) other than AnnualCreditReport.com in order to get their credit reports. It’s a good reminder; make sure that you and everyone in your family know not to fall for the deceptive ads for the other site (catchy though their jingles might be).
Anything Worth Doing is Difficult and Requires Sacrifice – Finally, a column from Kevin at No Debt Plan reminds us that though things might not always be easy, the things in life that are worth doing tend not to be. Getting your financial house in order, putting money aside for retirement, and getting in shape are all things that we should, nay, MUST do to have a good life, but the rewards are more than worth the pain.
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28
May
Posted in taxes by Roger, the Amateur Financier |
There’s a good chance you’re paying less in taxes than you think. Why, you ask? Because of the difference between your marginal tax rate and your overall tax rate. (Note: these discussions are going to focus on the American tax code, as that’s the one with which I’m the most familiar. Apologies to any international readers, but I can’t really comment on your tax system.)
When most people talk about their tax rate or their tax bracket, they are discussing their current marginal tax rate. This is the tax rate you will pay on the last dollar of (taxable) income that you earn. It’s important to know this tax rate so you know how much you will pay should you earn any more money; if you are in the 25% tax bracket, when you earn one hundred dollars more, you will have to pay $25 more in taxes.
However, the average tax rate you pay is the average of the tax rates you pay on each segment of your income. The first $8,350 of your taxable income, for example, is taxed at 10% (if you are single or married filing seperately), regardless of whether you earned $10,000, $100,000, or $1,000,000 the past year. A complete tax schedule can be found here.
What are the consequences of this difference? First, as already mentioned, your average tax rate is less than your marginal tax rate, and so you’re probably paying less in taxes than you might believe. If you earned $50,000 in taxable, non-capital gains income, you would be solidly in the 25% tax bracket. But the total income tax you would pay is $8670.50, for an effective tax rate of 17%. In the same way, your average tax rate will always be less than your marginal tax rate (unless you are earning less than $8,350 each year, in which case both rates will be the same 10%).
A second consequence is that going up a tax bracket will not have a huge impact on the amount of tax that you pay. You occasionally hear people going to great lengths to stay in the same tax bracket, from foregoing raises to cutting down on overtime, for fear that moving to the next bracket would cause them to lose money. However, as noted already, this is not the case; if you go from the 25% tax bracket to the 28%, you will only have to pay the higher tax rate on your additional income. If you go from $82,000 to $83,000, for example, you will only pay an additional $272.50 in taxes as a result; the previous amount you were paying in taxes on the $82,000 will remain unchanged. Moving up a tax bracket will decrease the amount of money you get to keep for each additional dollar of income, but will not require you to pay more on money you already earned.
Finally, and perhaps most importantly, it adds a bit of a wrinkle to choosing between a traditional and a Roth IRA, although not a huge one. Because your traditional IRA (and traditional 401(k), as well) contributions reduce the amount of taxable income you have, they will effectively cut down your taxes by the marginal rate you are currently paying. But on withdrawal of your money, you will be paying taxes according to the then-current tax schedule. Roth accounts, however, use post-tax contributions, so it’s the current average tax rate you need to consider for the contributions. Withdraws are tax-free, so it’s just the contributions you need to consider.
Confused yet? Let’s look at an example to see how this difference could end up being a wash. If you are earning $50,000 a year before your IRA contributions and put in the maximum amount (currently $5000), you will cut your taxable income down to $45,000 and reduce your taxes by $1250 (25% of $5000). When you retire, if you withdraw $50,000 a year from your account, have no other taxable income, and the tax rates are still the same (a great big if, especially when you are like me and are decades away from retiring), you will end up paying the same 17% average tax rate on those withdrawals. Compare that to a Roth; you will have to pay the 17% average tax up front, but when you take out your money at retirement, it’s tax free; you pay no additional taxes on the withdrawals.
Because in both cases, you will pay an average tax rate of 17% on your retirement money, it’s frequently noted that both a Roth and a traditional IRA have the same tax burden, as long as taxes stay the same. Tomorrow, we’ll look into some of the other factors that will influence which type of IRA is better for you.
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27
May
Posted in off topic by Roger, the Amateur Financier |
As of today, I’ve been at my temporary job now for one and a half weeks. The good news is, I do have a job, it pays pretty well, and I can handle the work load without too much trouble. The bad news is, the job takes up a substantial portion of my time when I used to do much of my writing (late at night is when I write best). Add in the housework and other things I need to do in real life, and I’m having a tough time getting my blog entries out.
As a result, I’m going to be cutting back on my posting schedule, and I will not be posting anything on the weekends from this point on. Hopefully, this will allow me time to build up an archive of posts for the future, as well as do some more promotion and maintenance work for my blog (which I’ve been neglecting up to this point). Plus, it seems as if there is little interest in my net worth statements or commentary on charities, so it should not be a huge loss.
Thank you all for reading my blog, and I hope that it continues to be a source of entertainment and education. Come again tomorrow, when I’ll be back to my normal money-related posts and other whackiness.
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