November 19, 2010

Is a Roth IRA the Right Choice for the Jones'?

Mr and Mrs Jones have done pretty well with their income and retirement savings.   Right now they make a combined income of $90,000 and they've accumulated $800,000 in their retirement accounts.   They are in their early 60's and just about to retire.

Mrs. Jones is a nurse and makes about $60,000 a year and Mr Jones is a maintenance man at the same hospital and he takes home about $30,000.

Using the Social Security Administration quick calculator I can estimate their SS checks.  Their individual social security checks are expected to be about $1650 and $1050 at age 66.  Thats a combined $32,400 from social security.

Their $800,000 retirement nest egg is spread across a few IRA's and 401k's from different jobs over the years. When they retire they plan to use the 4% rule to pull out 4% a year and hopefully it will last them their lifetime.  That gives them an initial retirement income of $32,000 per year from savings withdrawals.

Altogether with social security and IRA/401k withdrawals they are expecting a retirement income of about $64,400.   That will replace 71.5% of their current working income.

What to do with this years retirement savings?    They could choose to pay taxes on their income then put it into a Roth IRA or Roth 401k.    At retirement the money in their Roth IRA / 401k would be tax free.   Or they could put their money in a traditional IRA / 401k pre-tax and then pay taxes when they withdraw it at retirement.

Roth IRA / Roth 401k Choice

If they use a Roth IRA they will have to pay taxes on their money but what they save will be tax free.    They take in $90,000 and that would give them an income tax bill of $10,188 today leaving them $79,812.  If they then put $5,000 into a Roth IRA they have $74,812 left over to live on.   Their income puts them in the 25% marginal bracket so they pay 25% taxes on the money they put into their Roth IRA.

This gives them an extra $5,000 in their retirement savings.   Over the next few years lets say that doubles to $10,000 due to investment growth.

If they use the 4% rule on that $10,000 then they will have another $400 per year of tax free income.

Traditional IRA / 401k

They could put their money into a traditional IRA or 401k.    This would be pre-tax money so they could put more into retirement savings and still have the same amount after taxes to live on.   If they put $6271 into a IRA or 401k they would have a taxable income of $83,729  and a tax bill on that of $8,917.   That would leave them with $74,812 take home.

If they invested the $6,271 the same way and doubled it then it would be worth $12,542 at retirement.    If they withdraw 4% o that money then that gives them $501 and change each year.   However this money is taxable.   So they will have to pay taxes on it.

Given their expected post retirement income of $32,400 from social security and $32,000 from their current $800,000 retirement nest egg we can figure their expected retirement income tax situation.    Some but not all of their social security is subject to income taxes.   Their $32,000 in IRA/401k withdrawals is enough to make some of their social security taxable.   You can use the worksheet on page 27 of the form 1040 instructions to figure the amount of social security that is taxable.   This calculator will help you estimate the amount of social security that is subject to income taxes.      For the Jones' I ran it both ways and determined that $9,570 of their social security is taxable.    Combine that with their $32,000 withdrawals from IRA/401k and they have a taxable income of $41,570.   Their tax bill on that would be just $2,593.   If they add the $501 from their additional IRA/401k contribution then their taxable income is $42,071 and the tax on that would be $2,668.    So they are paying a marginal tax of $75  (2668 - 2593) on the $501.   They are in the 15% tax bracket.   That leaves them with $426 after taxes.

Summary:

The Jones have combined income of $90,000 a year and $800,000 in retirement savings all pre-tax.   They are nearing retirement.    If they put $5,000 into a Roth IRA today they could expect $400 annual after tax income at retirement.   If they put $6271 into a traditional IRA / 401k today then they could expect $426 in after tax income at retirement.   In this example they will come out ahead if they put their money into a traditional IRA/401k rather than a Roth.

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