Question 3: The benefits of early investment in Roth IRAs
Question 3: What is the amount available for consumption after tax from a $6,000 contribution to a conventional and a Roth IRA funded at age 20 and distributed at age 65 when the underlying assets earned 8.0 percent per year and the tax rate is 20 percent?
What additional considerations favor the choice of the Roth IRA over the conventional IRA?
Analysis:
Basic Calculation:
- The total wealth accumulated in a tax-deferred IRA of $6,000 invested for 35 years earning an average annual return of 8.0 percent per year is $88,712.
- The distribution of the conventional IRA is taxed at a 20 percent rate, hence the amount available for consumption from the conventional IRA is $70,970.
- The entire distribution of $88,712 from the Roth account is available for consumption.
Additional Benefits of the Roth:
- The contribution to the Roth could be used for an emergency without payment of tax or penalty.
- The distribution from the Roth is not included in AGI and does not increase the amount of Social Security benefits subject to tax. As a result, the tax savings for a person in the 20 percent marginal tax bracket may be higher than 20 percent of the distribution.
- People in retirement who have a year where they must distribute substantial funds from their retirement accounts will be forced into a higher tax bracket if their only source of funds is a conventional retirement account.
- All inherited IRA funds must be disbursed within 10 years, but Roth disbursements will not be taxed, and conventional IRAs will be taxed as ordinary income.
Go here for a list of financial tips, here for an article on why a Roth should be the vehicle of choice for young adults, and here for an article on the advantages of Roth articles.