November 18, 2010

Is a Roth IRA the Right Choice for the Andersons?

Mr and Mrs Anderson have an income of $45,000 and retirement savings of $145,000.   He is a teacher and she has been a stay at home mom and does not currently work.   Mr Anderson has a pension coming from his job as a teacher that should get him 60% of his current pay or $27,000 a year.   His Social security should come out to about $1,250 a month or $15,000 a year.  

Should they put $5000 into a Roth IRA or $5883 into a Traditional IRA?

Lets compare...

Roth IRA:

With a current income of $45,000 their tax bill is $3,108 and they are in the 15% tax bracket.   So they are paying 15% taxes or $750 on that $5000 for the Roth IRA.   After taxes of $3108 and the Roth IRA contribution of $5000 they would have $36,892 take home

Lets say they retire next year.   They will be able to pull money out of that Roth IRA tax free.   Their effective tax rate is 15%.

Traditional IRA:

If they put $5883 into a traditional IRA that will drop their taxable income down to $39,117.   Their tax bill on that would be $2225 giving them take home of $36,892

Only $1,250 of their social security will be taxable.    That gives them at taxable income of $1,250 plus $27,000 between the social security and pension for a total taxable of $28,250.   Currently that would put them in the 10% tax bracket and their tax on that amount would be just $955.

If they had the $145,000 of original retirement savings plus another $5,883 from the most recent traditional IRA contribution then that would give them a total of $150,883 in retirement savings.   If they withdraw 4% of that in retirement per year then that wold be another $6,035 of IRA/401k withdrawals.   The additional income would make more of their social security taxable so now $4268 of that would be subject to tax.   This would make their total taxable income $4268 of social security + $27000 pension income + $6,035 in IRA withdrawals for total taxable income of $37,303.   Their tax bill would be $1,953 and they'd be in the 15% marginal tax bracket.

Summary:    The Andersons have current income of $45,000 and savings of $145,000.    If they put $5000 into a Roth IRA they'd pay 15% tax rate on it today and be left with $5000 tax free.    If they put $5883 into a traditional IRA and then pulled it out at a 4% rate they'd pay 15% marginal taxes after retirement and be left with $5000 after taxes.    In this case its a wash, they pay 15% today or 15% tomorrow.

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