Stocks — Part VIII: The 401K, 403b, IRA & Roth Buckets

Posted: May 30, 2012 in Stock Investing Series
Tags: , ,

In Part IV we looked at some sample portfolios built from the three key Index Funds I favor, plus cash.  Those four are what we call investments.

But in our complex world we must next consider where to hold these investments.  That is, in which bucket should which investment go?  There are two types of buckets:

1.  Ordinary Buckets
2   Tax Advantaged Buckets

Now at this point I must apologize to my international readers.  This post is about to become very USA centric.   I am completely ignorant of the tax situation and/or possible tax advantaged buckets of other countries.  My guess is, that at least for western style democracies, there are many similarities and possibly you can extrapolate the information here into something relevant to where you live.  Or you might post a country specific question in the comments below.  The readership of jlcollinsnh has been growing quickly and there are a lot of savvy investors on board who may well be able to help.

Here in the USA the government taxes dividends, interest and capital gains.  But it has also created several Tax Advantaged Buckets to encourage retirement savings.  While well-intentioned, this has created a whole new level of complexity.  Volumes have been written about each of these and the strategies now associated with them.  Clearly, we haven’t the time or space to review it all.  But hopefully I can provide a simple explanation of each along with some considerations to ponder.

The Ordinary Bucket is, in a sense, no bucket at all.  This is where everything would go were there no taxes on investment returns.  We would just own what we own.  Easey peasy.  This is where we’ll want to put investments that are already “tax efficient.”

There are several variations of Tax Advantaged Buckets, and we’ll look at each.  These are the buckets in which we’ll want to place our less tax efficient investments.  In general this means investments that generate dividends and interest.

Let’s look at our four investments from Part IV:

Stocks.  VTSAX (Vanguard Total Stock Market Index Fund) pays around a 2% dividend and most of the gain we seek in in capital appreciation.  Ordinary Bucket.

Real Estate.  VGSLX  (Vanguard REIT Index Fund)  REITs (Real Estate Investment Trusts) invest in real estate and this is also a play for capital gains.  However REITS also tend to pay dividends, VGSLX in the range of 3-4%.  Tax Advantaged Bucket.

Bonds.  VBTLX (Vanguard Total Bond Market Index Fund)  Bonds are all about interest.  Tax Advantaged Bucket.

Cash is also all about interest but, more importantly, it is all about ready access for immediate needs.  Ordinary Bucket.

None of this is carved in stone.

There may be exceptions.  Proper allocation should trump bucket choice.  Your tax bracket, investment horizon and the like will color your personal decisions.  But the above should give you a basic framework for considering the options.

Before we look at the specifics of IRAs and 401Ks, this important note:

None of these eliminates your tax obligations.  They only defer them.

Fix this in your brain.  We are talking about when, not if, the tax due is paid.

There are many, many variations of 401K and IRA accounts.  If you are self-employed or work for the government, for example, each has its own variation.  We’ll look at the three basic varieties here.  The rest are branches from these trees.

401K/403b.  These are buckets provided by your employer.  They select an investment company which then offers a selection of investments from which to choose.  Many employers will match your contribution up to a certain amount.  Both your and your employer’s contributions are tax deferred, reducing your tax bill for the year.  All earnings are also tax deferred.  The amount you can contribute is capped.  In general:

  • These are very good things.  I always maxed out my contributions.
  • Any employer match is an exceptionally good thing.  Free money.  Contribute at least enough to capture the full match.
  • Unless Vanguard happens to be the investment company your employer has chosen, you won’t have access to Vanguard Funds.  That’s OK….
  • …Most 401k plans will have a least one Index Fund option.  Look for that.
  • When you leave your employer you can roll your 401k into an IRA preserving its tax advantage.  Some employers will also let you continue to hold your 401k in their plan.  I’ve always rolled mine.
  • Taxes are due when you withdraw your money.
  • Money withdrawn before 59 1/2 is subject to penalty.
  • After 70 1/2 money is subject to Required Minimum Withdrawals.

IRAs are buckets your hold on your own, separate from any employer.

– Deductible IRA.  Contributions you make are deductible from your income for tax purposes.  In general, you’ll want to use these if you are in a high tax bracket and are looking for a deduction to lower your immediate tax obligation.  Just like an 401K.

  • All earnings on your investments are tax deferred.
  • Taxes are due when you withdraw your money.
  • Money withdrawn before 59 1/2 is subject to penalty.
  • After 70 1/2 money is subject to Required Minimum Withdrawals.

– Non Deductible IRA.  Contributions you make are NOT deductible from your income for tax purposes.

  • All earnings on your investments are tax deferred.
  • Taxes are due on any dividends, interest or capital gains earned when you withdraw your money.
  • Taxes are not due on your original contributions.  Since these contributions were made with “after tax” money they have already been taxed.
  • Those last two points mean extra record keeping and complexity in figuring your tax due when the time comes.  A bad thing.
  • Money withdrawn before 59 1/2 is subject to penalty.
  • After 70 1/2 money is subject to Required Minimum Withdrawals.

– Roth IRA.  Contributions you make are NOT deducible from your income for tax purposes.

  • All earnings on your investments are tax-free.
  • All withdrawals after age 59 1/2 are tax-free.
  • You can withdraw your original contribution anytime, tax and penalty free.
  • There is no Required Minimum Withdrawal.
  • It can be passed to your heirs tax-free and will continue to grow for them tax-free.

All of these have income restrictions for participation.  These change year-to-year, here’s a current table:

In short:

401k/401b = Immediate tax benefits & tax-free growth.  No income limit means the tax deduction for high income earners can be especially attractive.  But taxes are due when the money is withdrawn.

Deductible IRA = Immediate tax benefits & tax-free growth.   But taxes are due when the money is withdrawn.

Non-Deductible IRA = No immediate tax benefit, tax-free growth and added complexity.  Taxes due when the money is withdrawn.

Roth IRA = No immediate tax benefit, tax-free growth and no taxes due on withdrawal.   A better Non-Deductible IRA, if you will.

Now, if you’ve been paying attention, you might be thinking “Holy cow!  This Roth IRA is looking like one very sweet deal.  In fact it is even looking like it violates what jlcollinsnh told us to fix in our minds earlier: ‘None of these eliminates your tax obligations.  They only defer them.‘”   Gold Star.  While you have to contribute money you’ve already paid tax on, that money then grows tax-free and it remains tax-free on withdrawal.  This is something very special and it is what makes the Roth far and away my favorite of these tools.

Because I’m the suspicious type, and the tax advantages of a Roth are so attractive, I start thinking about what might go wrong.  Especially since these are such long-term investments and the government can and does change the rules seemingly on a whim.  Two things occur to me:

1.  The government can simply change the rules and declare money in Roths taxable.  But since Roths are becoming so popular and are held by so many people this seems more and more politically unlikely.

2. The government can find an alternative way to tax the money.  Increasingly in the USA there is talk of establishing a national sales tax or added value tax.  While both may have merit, especially as a substitute for the income tax, these would effectively tax any Roth money as it was spent.  This seems more likely to me.

Finally, lets talk a bit about withdrawal strategy.  Except for the Roth, all of these have required minimum withdrawals at age 70 1/2.  Basically this is the Feds saying “OK.  We’ve waited long enough.  Time to pay us our money!”  Fair enough.  But for those of us diligently building FI (financial independence) there is going to be a very large amount of money in these accounts.  Pulling it out in the required amounts on the government time schedule could easily push us into a higher tax bracket.

Assuming when you retire your tax bracket drops, you have a window of opportunity between that moment and age 70 1/2.  Let’s consider an example.

A married couple retires at 60 years old.

  • They have a 10 year window until 70 1/2 to reduce their 401k/IRA holdings.
  • The 15% tax bracket is good up to 69k.
  • Personal exemptions and the standard deduction are good for another 19k.
  • They have up to 88k in income before they get pushed into the 25% bracket.

If their income is below 88k they should seriously consider moving the difference out of their IRA and/or 401k and taking the 15% hit.  15% is a very low rate and worth locking in.  So, if they have 50k in taxable income they might withdraw another 38k.  They could put it in their Roth, their ordinary bucket investments or just spend it.

There is no one solution.  If your 401k/IRA amounts are low you can just leave them alone.  If they are very high pulling them out even at a 25% tax might make sense for you.  The key is to be aware of this looming required minimum withdrawal hit so you can take it on your own terms.

Addendum — October 17, 2012:  Health Saving Accounts (HSAs)

Some readers may have access to HSAs.  These can be extraordinary useful retirement tools, in addition to providing funds to cover health care costs.  My pal, The Mad Fientist, has put together a terrific review on HSAs:

Since I couldn’t have said it better myself, I won’t.

Addendum II– February 12, 2013:  IRA/Roth IRA Conversion Strategy

Again my pal, The Mad Fientist, has put together a terrific post; this time on an IRA/Roth IRA conversion strategy that is particualry useful for those of you planning an early retirement:


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  4. klr says:


    I stumbled onto your blog this week and have caught up with all your money posts. I would like to say that your guidance has probably saved me months of research and lots of frustration. Thank you for the great topics, but I am now trying to figure out my plan and my head is spinning.

    I’m 26 and have recently graduated from college, and decided to get my financial life in order. Luckily, I was able to find a great job and have no debt. I am working on saving up my emergency fund (roughly 24% of my income is going into it) and now focusing my efforts on investments.

    I was also lucky that my grandparents seeded an investment fund for all of the grandchildren when each was born. It has been managed by a financial advisor for years, and your posts have confirmed my thoughts that I can do better. It currently has around $35,000 in it in 12 different mutual funds.

    Next June, I will be eligible to enter my employer’s 403(b) plan and also a pension plan. I am able to put 3% of my income into the 403(b) plan and they match with 2.5%. It looks like I will be able to enroll in Vanguard’s total stock market index fund. There is also an optional traditional IRA plan that I can contribute up to the maximum allowed by the IRS. It seems that after learning more about all of this, the 5.5% of my yearly salary into my 403(b) is nowhere the maximum allowed by the IRS, which is a little discouraging.

    I don’t think I’m going to do the optional IRA account and instead do a Roth IRA on my own. What is your suggestion on getting rid of my financial manager and all the mutual funds and buying into VTSAX? I don’t fully understand the tax implications that are involved in that. Correct me if I’m wrong, but $5000 would go into the Roth and the rest into a traditional account. I think I know the answer, but do you think it is fine to have the investments in my 403(b), Roth IRA, and my regular account in VTSAX?

    Sorry for the long post, but any assistance would be greatly appreciated.


  5. jlcollinsnh says:

    In the comments over here:

    JTH posted the following question:

    “Getting ready to retire (30 days). Corporate job. Pension and 401k. Do I take a lump sum on pension or take an annuity?”

    Since this post is a better fit, I’m taking the liberty of answering here. Hopefully more people with a similar concern will see it.

    So, JTH, Congratulations on your pending retirement!

    OK, let’s take a look.

    This is not a simple “do this not that” kinda question. What is best for you is a very personal decision. But with a few guideposts to consider you can walk yourself thru the process.

    First, take comfort in the fact there is really no “bad” decision you can make here.

    Unless you take the lump sum and put it on red in Vegas and up comes black. That would be very bad.

    So question #1 is how confident do you feel in your own investing abilities? If there is any chance at all that you’ll blow this money: No lump sum for you!

    This would also apply if you have any pending lawsuits or judgements against you.

    If you decide to take the pension/annuity you’ll find The insurance companies that operate these things are very good a figuring the odds. They can calculate within a whisker how long people with your profile, and that of your spouse, will live.

    You will notice that you have several further options if you take the pension/annuity. Payments just to you until you die. Payments until both you and your spouse die. Guaranteed payments for a certain number of years. Built in inflation protection. This list is endless.

    Inflation, in my view, is the biggest risk with pensions/annuities. If you are retiring at, say, 60 and think you might live to be 90, that’s thirty years. Even at modest inflation rates the buying power of that check will be very much lower then than now.

    But each item you select lowers your monthly check. Again, they are calculating the averages very precisely. So there is no one “right” answer.

    But those are only averages (which is what matters to them) and you are unique.

    So question #2 is: how long do you and your spouse expect to live?

    The longer you expect to live the better the pension/annuity option looks. And guessing at this will help you choose the benefits best suited to your personal profile.

    The shorter you expect to live the better a lump sum looks.

    Question #3 is: do you want to leave this money to your estate/heirs? If so: lump sum. Although one of the options you may be offered is a smaller monthly check with some money to be passed on.

    Consider, too, that you already have another annuity coming, and this one is inflation adjusted: Social Security. Many of the same considerations as above can steer you in selecting when to start drawing on it. Again, the actuaries have figured to the whisker what payouts to allow at what age. So there is no one “right” answer. But looking at your own situation you can figure what will likely work best for you.

    The nice thing about SS and pensions is that those checks just keep rolling in with no effort. As we all get older and less sharp, having that guaranteed income we can’t lose is a pretty attractive option.

    That said, I took my own small pension as a lump sum.

  6. Austin says:

    Hi Jim,

    Thanks so much for the feedback. Always nice to know that with starting early comes simplicity in an approach.

    A follow-up: I absolutely love the comparison of dollars to employees, and am eager to put mine to work! That said, I’ve often been concerned with the prospect of putting a down payment on a home in the next 5-10 years (I’m 25 and rent, no student loan debt….yet). How do we marry the idea of “spend less than you earn, invest the rest, don’t accrue debt” with the potential of purchasing a home and needing liquid funds to do so?

    I’m sure there’s a simple, simple answer (government exception to withdrawing from 401K for first-time homebuyers?) so figured I’d pose the simple-minded question :)

    Thanks again

    • jlcollinsnh says:

      Hi Austin….

      The great thing about your dollar slaves is once you get them started they work tirelessly 24/7 for you. At 25 and no debt you’re at a wonderful starting place.

      Regarding a home, if you haven’t already, read:

      Most often owning a home is an expensive indulgence. Running the numbers will tell you if it makes financial sense.

      Of course, as with any indulgence, there are lots of reasons to want a home beyond just money.

      The whole point of having F-you money is to expand our lives as best suits up. But accumulating the money comes first.

      As with anything, I wouldn’t buy one, or anything else, unless I could easily afford it. In the case of a house that would mean at least 20% down and no more than 25% of my monthly income to service the mortgage, insurance, taxes, repairs and maintenance. If that sounds like a high bar, well, it is.

      Most people shouldn’t own a house. When you do, lots of people make money, but not you:

      The real estate brokers
      The banks
      The insurance companies
      The utilities
      The appliance companies
      The furniture companies
      The home improvement stores
      The garden stores
      The painters, carpenters, plumbers, roofers, exterminators, electricians,
      and more I’m not thinking of just now.

      Suddenly you are pulling your little dollar slaves off the job and sending them away to live with somebody else.

  7. vvroom says:

    Another great way to lower your tax bracket is to live 330 days out of 12 months outside of USA to qualify for the foreign residence tax-deduction. As of 2011, that reduced my taxable income by $92K. Its adjusts up every year due to inflation.

    If you are expecting a big hike in your tax bracket from withdraws, live overseas. Then in the same tax year, max-out your withdraws to $88K + $92K. You will rake in $180K of income, but still at 88K tax bracket.

    • jlcollinsnh says:

      Hi Vvroom…..

      Very interesting point you’re making here. Can you elaborate for us? My understanding is that:

      1. The US government taxes any and all of the income earned by it’s citizens no matter where in the world thy live and no matter where in the world they earn it. This, I gather, is a uniquely aggressive tax policy.

      2. To off set this, the first 92k earned outside the US in tax free.

      This is what you are saying:

      using my example above of 88k in income ceiling to stay in under the 15% tax bracket, living overseas at least 330 days would allow for adding an extra 92k to our income with no further tax due.

      This would be a great way to empty 401k and IRA accounts tax free.

      But, doesn’t that 92k taxable income reduction apply only to income earned outside the USA?

      Can you tell us more about your situation?


      • Vvroom says:

        There’s actually two ways to qualify for this huge deductions

        1. Physical Presence Test. Accrue 330 days out of 12 months outside of US states and territories. These days do not have to be consecutive days.

        2. Bonifide Residence Test. Prove you are a permanent residence in your foreign country. I think you can come visit your family at the US more than 35 days in a year if you qualify.

        IRS.GOV has the forms with info.

        No, the income does not have to be foreign earned. All my income is domestic (US based employer). But physically, I was outside US for 330 days of 12 months.

        Bonifide Residence Test has the disadvantage of applying for residency at your new place and paying their tax (if any).

        To make physical presence test work, you can visit several countries using a tourist visa for 330 days. Then come back to the States and reap the rewards.

  8. Christina says:

    Great article- as always. I have really enjoyed reading your blog!

    I have a question for you, if you don’t mind indulging me for one moment. I am a novice at investing, but my husband and I do have a 401K and a Roth IRA. Our Roth is in several Fidelity Funds through our insurance company. The company charges $25 a year for the Roth, plus whatever fees Fidelity charge- which I am finding impossible to discern.

    I figured we have two options in regards to our Roth:

    1. Instead of having the Roth in several different Fidelity funds, moving them all to their Index Fund. If Fidelity is a low cost, low fee service I would like this option as it is simpler. Do you know much about Fidelity? (I have tried researching on their website, but find it difficult to get answers)

    2. Moving all of our Roth to a Vanguard Roth, where I know the fees are low.

    What would you suggest? Of course, I know you are simply giving suggestions and I am responsible for my own decisions. I think I know what your advice is, but I feel like I need a second opinion before I make such a critical decision.

    Thank you so much in advance! For a novice investor, it is wonderful to learn from somebody who has been so successful!

  9. Carolina on My Mind says:

    Hi, jlc — I’ve been learning from your blog for a few months, and I’m finally inspired to comment because this is exactly the question I’ve been struggling with for a while. I know how I want to allocate my investments, but I could never figure out what should be in my 401(k) and what should be in my after-tax accounts. Now, just like that, I have a strategy. So thank you!

    This whole series has been really, really helpful.

    • jlcollinsnh says:

      Hi Carolina…

      thanks so much for letting me know.

      Actually, I added this post to the series almost as an after thought and yet it seems to have resonated with folks. Glad you found value in it!

  10. Josh says:

    Great article and glad I found you by way of MMM. I’m fortunate enough to have the option of a Roth401K with vanguard and take full advantage of it, up to the match. Is this becoming more common? I know it was new for us last year and most people don’t know about the option or understand it. I’ve had to explain it to everyone I talk to. This article may help a bit. Thanks.

    • jlcollinsnh says:

      Welcome Josh…

      ….good to see you here!

      With Vanguard funds and a Roth 401k on offer sounds like your employer has it together!

      The Roth 401k is relatively new and for some reason has been slow to catch on. No surprise you’ve been having to explain it. :)

      The difference between it and a regular 401k is the same as the difference between a Roth and a deductible IRA as described above. And, of course, being a 401k the amount you can contribute is much higher than an IRA.

      In other words, a very good thing.

      Especially for anyone in an already low tax bracket and/or those of you planning an early retirement (your contributions, but not earnings, can be withdrawn tax and penalty free anytime as long as you’ve held the account 5+ years).

      Feel free to correct or add anything here Josh, and thanks for pointing it out!

  11. KC says:

    I really appreciate this article. I’m always telling myself to just “decide already!” where the money should go and leave it on auto pilot. I have major issues with analysis paralysis!

    Here’s a post from MMM I thought was an interesting take on retirement accounts…

    Thanks for any input.

    • jlcollinsnh says:

      Thanks for the link KC….

      …I hadn’t seen that one from MMM before. Great addition to this conversation and I like the 401k/Roth strategy for early penalty-free withdrawals. Hadn’t heard that one before.

  12. A says:

    Hi jlcollinsnh —

    I’ve been struggling with determining where to put money (ordinary bucket vs tax advantaged bucket) for years, and I’m not much closer to settling the debate with myself this year than I was 5-10 years ago. Though this article illuminates things a bit more for me. Thank you.

    I’ve basically defaulted to satisfying my desire for instant (short term) gratification, i.e. reducing the tax burden I have today. So I max out contributions on the tax advantaged buckets — 401k and traditional IRA — and I plough the rest of my money into the ordinary bucket (mostly index funds, some individual stocks, and cash savings). At 35, single, renter, no kids, no debt, low expense lifestyle, and $70k per year salary, my after tax money gets allocated something like this: $21,500 to the tax advantaged 401k/IRA bucket, $26,000 to the ordinary bucket, and $15,000 in living expenses.

    I don’t know if deferring taxes on the $5000 I’m currently putting into the Traditional IRA and instead paying the taxes now and contributing to a Roth IRA would make much difference in the long run, but my aversion to paying the taxes now is motivating my to stay the course I’m on. But I welcome any compelling argument for me to reconsider, if you have any given my particular situation.


    • A says:

      …guess it would be more accurate for me to say “my salary gets allocated something like this: $21,500 to the tax advantaged 401k/IRA bucket, $7300 to federal+state taxes, $26,000 to the ordinary bucket, and $15,000 in living expenses.”

    • jlcollinsnh says:

      Hi A….

      Well first, major league kudos on the 67% savings rate! That alone should keep you golden.

      Here’s some thoughts:

      While I appreciate your aversion to paying taxes, at 70k you are already in a fairly low rate, even before the 21.5k deduction.

      With your savings rate, if you are planning to work anything like a full career (that is to 60+ years old) your retirement accounts will be HUGE. Pulling all that money out could easily put you in a higher bracket than today’s.

      Personally, I’d be inclined to begin a Roth.

      BTW, be sure to read Patrick’s comments below.

  13. Danielle says:

    Hi Jim, MMM reader here. First off, I’m enjoying your blog a lot – these stock posts have been immensely helpful. As for investing strategies for ER folks, it seems like a good game plan would to be to max some contributions to a traditional IRA or 401k to reduce tax burden in the short term and use that investment for “old man/lady money” (how ever much you calculated that you’d personally need), then have a Roth to tap into pre-59.5 retirement needs (withdrawing deposits without killing too much investing momentum) if necessary. Does that make sense to you?

    I plan on opening a Roth and also a regular investing portfolio at Vanguard to get in the game, however at the moment I only have funds to choose one (and I already have a 401k started). Given that I’m 26 and would like to retire in 10-15 years, which one would be better (or easier to get my feet wet with)?

    • jlcollinsnh says:

      Thanks Danielle….

      …good to hear it’s helping and glad to have you here.

      I like your plan and, if you haven’t already, check out the link KC provided above. It’ll take you to an excellent MMM post on this exact subject.

      Since you are 26 and, I’m guessing, in a low tax bracket this is the order I’d suggest:

      401k up to full company match, if any.

      If you happen to be in a very high tax bracket:

      401k Max
      Deductible IRA

      • Austin says:

        Hi Jim,

        New but avid reader. Had the same question as Danielle above, and am 25 myself. Only one follow up: Following the plan of:

        1) 401K up to full company match, if any (already doing this)
        2) Roth
        3) Regular

        is it accurate to say that the Roth should be backed by VBTLX and VGSLX, and only after putting $5K-worth into that IRA backed by bonds and REITS, move remaining money to VTSAX? Reason i ask is because that seems to follow your tax-advantage/non-tax advantaged bucket rubric, but is somewhat in violate of “VTSAX = primary building block” gospel. Please advise, thanks!

        • jlcollinsnh says:

          Thanks Austin,

          and welcome. Great question!

          If you are going to hold VBTLX (bonds) and/or VGSLX (REITS), yer ideally both belong in a tax advantaged account like an IRA, ROTH or 401k. The reason is they throw off more divedents and interest that would be taxable otherwise than VTSAX (stocks).

          but the more important question is wether you should hold these at all. both belong in a portfolio to smooth the ride and:

          VBTLX is a hedge against deflation.
          VGSLX is a hedge against inflation.

          I hold both for these reasons, but I’m an old guy.

          Over time, VTSAX will very likely outperform both, but expect a wild ride along the way.

          If I were 25, (and oh how I wish it could be so!) I’d put everything in VTSAX and ride out the storms. 30-35 years from now I’d look to add the other two.

          Thinking back at all the investments I’ve tried over the past 36 years since I was your age, some blew up and some outperformed. But if I had ignored them all and simply bought VTSAX and added to it as I could, I’d have over twice the net worth I do today.

          Even if I’d done it with VBTLX and VGSLX in the mix I’d be far ahead.

          Just don’t lose your nerve in the dark times and there will be dark times.

  14. Patrick says:

    It’s interesting to note that the only mathematical difference between a Roth and Traditional, deductible IRA is the tax rates, if you ignore the 70 1/2 required withdrawal. I can give a quick proof…

    For a starting amount, x, and an annual rate of return, i, the way to calculate the return after one year is x(1+r). (If you have $100 invested at 5%, at the end of a year, you’ll have 100(1.05) = 105.) To accumulate another year, tack another 1+r to the end, with the idea that r could vary year to year. Let R = (1+r1)(1+r2)…(1+rn), with each r being another year’s specific rate.

    If the tax rate is t, then, for a traditional IRA, your total due in taxes is: x*R*(1-t). In English, take the initial investment, multiply it by all of the annual rates of return, and take out taxes. For a simple example, take $100, invested for 2 years, with rates of return 10% and 3%, in the 15% tax bracket. 100(1.1)(1.03) = 113.3 – 15% = 96.31.

    For a Roth, the equation becomes x*(1-t)*R. Take the initial investment, take out taxes, and multiply it by all of the annual rates of return. Using the same numbers as above, 100 – 15% = 85 * (1.1)(1.03) = 96.31.

    Because multiplcation is commutative, these calculations are equal, provided t is equal. If you expect to be in a higher tax bracket in the future, you would want a Roth, because then you would pay taxes now, in your lower tax bracket. If you expected to be in a lower tax bracket in the future, you would want a traditional, deductible IRA. So you can’t say which is better unless you can determine this…you’ll likely have less income in retirement, so your bracket might drop, but taxes are low now, and income tax increases might be a way for the feds to get a handle on the deficit.

    • jlcollinsnh says:

      Wow, Patrick….

      thank you!
      what a great, great addition to this post.

      Even if I did need my second cup of coffee to follow the math. ;)

      I took the liberty of highlighting in bold the conclusions in your last paragraph. and what you say also applies to a 401K v. Roth.

      Since, especially for a young person it is very difficult to predict future income and tax rates, I’d still lean toward the Roth. That’s how I’ve steered my 20-year-old. As someone looking looming Required Minimum Withdrawals I can tell you avoiding them with a Roth is a big advantage.

      In addition, as serious a challenge as the deficit is, increases in the income tax are politically unlikely. Except the Bush Tax Cuts which, if only due to gridlock, will in all likelihood be allowed to expire.

      More likely, I believe, will be some sort of National Sales or Value Added Tax. Along with inflation which is a great deficit reducing tool, although hard on the creditors.

      • Patrick says:

        The math is definitely fun! :) I agree that a young person should lean more toward the Roth since their income is likely low enough to put them in a low tax bracket, and then in the middle of their careers, switch over to a traditional/401(k). For an average-Joe traditional retirement, I imagine people won’t have trouble making their minimum withdrawals, because they’ll likely come close to exhausting the whole thing.

        For the early retirement folks, who save tons of money, it might still be worthwhile to max out the deductible savings early…if you do it like MMM, you’d have 150k/year of income before retirement, and about 35k/year after. It might still make sense to get that up-front deduction for maxing a 401(k) since there’s such a wide difference between the tax brackets. (After exemptions and the child tax credit, I don’t imagine he pays much taxes at all any more.) The big drawback is the required minimum withdrawals, but I wonder if they’d put you back up in that same high tax bracket you were in to begin with…

        There is one other plus of the Roth…the maximum contribution limit. In paying the taxes up front, they are not part of the contribution limit. So, given a limit of 5k, you can put as much as x(1-t)=5k into your Roth, but only x=5k into your traditional, and in the traditional, you’d have to pay taxes later. A contribution of 5k in a traditional IRA is roughly equivelant to one of 5,882 pre-tax into a Roth, but still comes under the 5k limit…I hope that makes sense… :)

        It’s an interesting conundrum, but at least it provides some useful talking points.

        • jlcollinsnh says:

          more great points and again I’ve taken the liberty of highlighting a couple.

          The strategy in your first paragraph makes perfect sense. Roth v deductable IRA/401k contributions should idealy change with your income.

          and I love the point you make in the last. that’s been rattling around in my head but I couldn’t quite get it out. thanks!

  15. Matt says:

    Very timely article. I have slowly been moving towards investing and was struggling to understand what investments to make in what accounts. With something like the bond fund and the REIT, are you able to set up a Roth that consists of those two funds? Rookie question I know.

    • jlcollinsnh says:

      Hey Matt….

      Welcome! No question is rookie. All questions are rookie. Zen for today. ;)

      The answer is: Yes.

      You would contact Vanguard (assuming that’s the company you’re going with), send them the money and provide instructions as to which funds.

      For instance, let say you are just starting a new Roth with the $5000 max you are allowed to contribute for 2012. You might put $2500 each in VBTLX and VGSLX.

      The EXACT way I would do this is to open a money market fund with the 5k. Once that is established you can easily move the money to the other funds right on the Vanguard website.

      You’ll find their phone number at any of the links I provided. They are very helpful and will be happy to walk you thru the process.

      If you are going to rollover an existing IRA definitely call them. They’ll make it a breeze.

      Tell ’em jlcollinsnh sent ya! They won’t have a clue who that is, but why not! :)

  16. LtotheBmoney says:

    I am so glad you wrote this, because I am wanting to move my Roth at USAA to Vangaurd. If I can invest more than $5k per year, should I transfer into a fund like the VTSAX as a Roth and open a seperate “regular bucket” index fund and throw as much money into this as possible? You, Dave Ramsey, and MMM rock!

    • jlcollinsnh says:

      If I understand you correctly, yes. Here’s what I hear you saying:

      You want to be entirely invested in VTSAX.
      You have more than $5000 to invest each year.
      You plan to open a Roth bucket and put a VTSAX investment in it for $5000.
      You plan to open a second VTSAX fund investment in an Ordinary Bucket for every extra penny you can spare.

      That is exactly what I recommend for young people.

      So, do we rock in that order? :)

      • AB says:

        I want to do the same thing as Bmoney, move my USAA Roth over to Vanguard. I was planning on using the Roth as my bond and REIT funds, and doing the $2,500 to both funds each year, then having the stocks fund in a taxable account. My question is this, I currently have my Roth invested in individual stocks. If I were to move the IRA over to Vanguard, will the stocks still be in it, or would I have to sell them with the USAA brokerage and then move just the cash over?

        • jlcollinsnh says:

          Hi AB….

          You can move your Roth, and the individual stocks, directly to Vanguard. Then, if you prefer to have the money in the bond and REIT funds, you can simply sell the stocks and move the money into the funds.

          It is very important to be sure you do all this within the Roth bucket so you avoid tax and penalties.

          If you call Vanguard, they can walk you thru the process.

          good luck!

  17. Shilpan says:

    Another gem article Jim. As you know, I am a big advocate of the national sales tax. As you’ve pointed out, Roth IRA investment will be taxed if that money is used for the purchase. But, the savings by avoiding double taxation on your earned income itself will be more than 23% to begin with. So, even if you pay taxes on Roth IRA — or for that matter any dollar spent on purchase — savings will offset national sales tax.

    • jlcollinsnh says:

      Your article awhile back on the sales tax is what made me think of it!

      Of course for us retired guys without earned income there is no offset with the change.

      Still, it is an idea well worth consideration. Any change in the tax code, however worthwhile, will always have a few that fair less well than before. But that’s no reason not to change.

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