Tax the seed or Tax the Tree?

Tax the seed or Tax the Tree?

We have already discussed the path to future financial independence involves starting to save early. The first action is to invest in a company 401(k) or 403(b) plan up to the point of the match. I’ve explained this process already in my Calculating Contributions post.

The next thing to do is take advantage of an IRA account. There are two main types of IRA accounts, a Traditional IRA and a Roth IRA. For the 2008 tax year, both types of accounts allow contributions up to $5,000.

Why the IRA over the 401(k)?

Before diving into the two types of IRA accounts, I want to clear up the reason for utilizing an IRA account instead of increasing 401(k) or 403(b) contributions. A typical company’s 401(k) account allows for employees to choose from 17 investment options. I double checked my company’s plan held at Fidelity, and it limits me to 25 investment funds. These few options have to cover many asset allocation classes: large-cap, small-cap, emerging markets, bonds, target retirement, etc. This means there are 2-3 funds for each category at most, and that’s not much to pick from.

IRA accounts help overcome these limitations by allowing almost any type of investments. Passive investors can choose a couple of mutual funds or ETFs, while active investors can choose individual equities, create bond ladders, and even write call options.

Which type of IRA account to choose?

Let’s first discuss the differences between the two accounts. The income limitations for a traditional IRA account may prevent this type of account from even being an option for some people. The table below shows all values that apply to someone that is single. For those who are married filing jointly just double all numbers and for anyone else, the source for the table below is an IRS news release that shares additional info:

Traditional IRA

Roth IRA

2008 Contribution Limit

$5,000

$5,000

2008 Adjusted Gross Income Limit before phase out

$53,000

$101,000

Deposits – Tax Implication

Tax Deductible
(Pre-tax earnings used)

No Deduction (Post-tax earnings used)

Withdrawals – Tax Implication

All Withdrawals are taxable

Withdrawals are tax-free

So What’s the Difference?

Short Answer: Nothing, that is if your tax rate never changes.

Long Answer: Your current vs. future tax rate decides which option is better.

  • Higher tax rate now than anticipated for the future – Traditional IRA (applies to very few people)
  • Lower tax rate now than anticipated for the future – Roth IRA

For anyone interested in a complicated number crunching exercise that shows the exact difference between the two accounts lies in your tax rate, go here.

Related posts:

  1. Left your employer without taking your 401K?
  2. Help! My 401(k)/403(b) is plummetting!