Albert Edwards is in his early 30s and is thinking about opening an IRA. He can\

Question

Albert Edwards is in his early 30s and is thinking about opening an IRA. He can't decide whether to open a traditional/deductible IRA or a Roth IRA, so he turns to you for help. To support your explanation, you decide to run some comparative numbers on the two types of accounts; for starters, use a 25-year period to show Albert what contributions of $5,000 per year will amount to (after 25 years) if he can earn, say, 10 percent on his money. Will the type of account he opens have any impact on this amount? Explain. Assuming that Albert is in the 15 percent tax bracket (and will remain there for the next 25 years), determine the annual and total (over 25 years) tax savings he'll enjoy from the $5,000-a-year contributions to his IRA. Contrast the (annual and total) tax savings he'd generate from a traditional IRA with those from a Roth IRA. Now, fast-forward 25 years. Given the size of Albert's account in 25 years (as computed in part a), assume that he takes it all out in one lump sum. If he's now in the 40 percent tax bracket, how much will he have, after taxes, with a traditional IRA as compared with a Roth IRA? How do the taxes computed here compare with those computed in part b? Comment on your findings. Based on the numbers you have computed as well as any other factors, what kind of IRA would you recommend to Albert? Explain. Would knowing that maximum contributions are scheduled to increase to $7,000 per year make any difference in your analysis? Explain.

Explanation / Answer

a. Tax implications are the major difference between traditional and roth ira. In traditional ira contributions are made out of pre tax earnings unlike roth ira, which makes contributions out of post tax earnings. However as the question specifies the amount of contribution made , it is assumed that the contribution 5000$ are well within the limits. An investment of 5000$ per year @10% interest will give an amount equal to 5000*25+interest @ 10% on outstanding balance every year that comes to 545908.8$ at the end of 25years in the fund. However the final amount that will be recieved by the investor depends upon the type of ira. If the contribution is made to traditional ira then then the sum recievable will be taxed according to the tax rate applicable to the investor and the remaining amount will be the recieved by the investor however in roth ira there is no tax implication and the entire amount will be recieved tax free provided applicable conditions are satisfied in tax laws.

b. Tax benifit in traditional ira -

Annual - 5000*15% = 750$

in total - 750*25 = 18750$ ,

note - above sum is not adjusted to time value of money.however on withdrawl of the amount from the fund may be subjected to tax rate applicable in the year of withdrawl.

tax benefits in roth ira -

Yearly benefits are not available because the contributions are already made out of post tax earnings, however on the withdrawl of fund after years will not be subjected to tax. The entire amount will be recieved tax free.

c. Case where tax rate increases to 40% -

annual tax benefits in total as per part b 18750$ @ 15% tax rate, however in the year of withdrawl if the tax rate is 40% then the tax deductible in traditional ira account is 545908.8 *40% = 218363.52 $. however there is no such difference in roth account as the entire withdrawls are tax free. Here it is to be observed that if the tax rate is increses over the period then the traditional ira would not be preferable as the interest on the fund remains stable over the period. This is an obvious understanding in the answer that tax benefits in part is less than the tax payable in part c.

d. From the above calculations it is possible to tell that if the tax rate is in increasing trend then it is preferable to in invest in roth ira. Hence albert is preferable to invest in roth ira where he gets more benefit at the time to withdrawl when compared to traditional ira. Even if the maximum amount of contribution is increased to 7000$ it is preferable to invest in roth ira account to get more benefit to the investor provided the conditions specified in the tax laws are properly complied.

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