2. A consumer has decided to set aside $2000 out of her income in the current ye

Question

2. A consumer has decided to set aside $2000 out of her income in the current year and save it for retirement. She has the choice of putting all $2000 in a traditional IRA or else putting all $2000 in a Roth IRA. What factors should determine her choice? Be as specific as possible. To simplify the problem, you may assume that she knows her marginal income tax rate and knows the marginal income tax rate she will have to pay in the first year of her retirement when she will withdraw the $2000 IRA deposit and the full return on it.

Explanation / Answer

Following are the factors that would determine the choice:

1. current vs future tax rates, - Current tax rates means the marginal tax rate that will be paid today (or the marginal tax rate on the deduction that would be received) by contributing or using a pre-tax retirement account versus contribution or converting to a Roth account. Future tax rates means whatever tax rate would apply to the funds in the retirement account when withdrawn in the future – ostensibly in retirement, or possibly even by the next generation if the retirement account is not expected to be depleted during the lifetime of the owner.

2. impact of required minimum distributions - Roth IRAs (although not Roth 401(k) accounts) is that they are not subject to required minimum distributions (RMDs) during the lifetime of the account owner, while traditional IRAs are. The net result is a slight benefit in favor of the Roth IRA, for the simple reason that it allows more dollars to stay inside their tax-preferenced wrapper.

3.) Contribution Limits and the Embedded Tax Liability

4) State Estate Taxes

avoiding lifetime RMDs, state estate taxes, and paying IRA tax liabilities with outside dollars are all benefits of using a Roth IRA over a traditional IRA. However, the reality is that the driving force on wealth creation – or destruction – is still a comparison of current versus future tax rates. As a result, even with all the other factors working favorably, a Roth can actually still be a wealth destroyer if future tax rates were going to be much lower for that individual client when the funds are withdrawn (either by the client in retirement, or by heirs in the next generation).

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