Roth IRAs, Traditional IRAs and Taxable investments
Lately there's been a lot of talk about Roth IRAs, particularly about the possibility of converting traditional IRAs into Roths. The trigger for much of this discussion is the fact that as of the beginning of 2010, many more people are now eligible to make the conversion. Until now, the law allowed conversions only for folks whose income was below $100,000. That cap has now been lifted, so suddenly many folks who previously couldn't consider conversions now can.
Before we talk about conversions, however, and the potentially complex calculations which can go into figuring out if doing a conversion makes sense, we'd like to talk about traditional and Roth IRAs themselves.
And before we talk about any IRAs, however, let's explore briefly the tax consequences of regular, old-fashioned taxable savings, starting with one's earnings. The cycle goes like this:
1. Earn money
2. Pay income taxes
3. Invest that money - buy stocks, bonds, or stick it in a savings account
4. Each year, pay income taxes on some of the investment's earnings (interest payments, dividends, etc)
5. Sell off or otherwise liquidate the investment
6. Pay taxes again on the gains in that investment (assuming you sell it for more than you paid in the first place)
7. Spend the money
As you can see, there are several stages along the way during which taxes are paid. Depending on which stage and how often, that tax drag can be quite substantial. Let's do an example with a pretty unfortunate case - suppose the investment was simply to put the money into a savings account which throws off fully taxable interest. For this example, we are going to make several assumptions - about tax rates, the investor's income level and the rate of interest paid by the bank. We are going to leave out State income taxes because it varies a lot by state, though in certain states, it can make a huge difference (e.g. CA has a 9.3% tax on most income!) Moreover, to keep it very simple, we are going to assume that those rates do not change, and we will follow the life-cycle of a specific chunk of earned money.
1. Earn money: $5000
2. Pay income taxes (25% of $5000 is $1250): $3750
3. Put $3750 into a savings account which earns 2% (Note that current savings account rates are less than that, but they've varied a lot over the years)
4. After a year, our savings account earns us $75 interest, on which we pay 25% income taxes of $18.75, so we actually only earn, after taxes, $56.25. Add that to our savings account, which now has $3806.25
[repeat this cycle for however long the investment is left alone. We will assume 25 years]. We end up with $5441.05
5. Since this is a savings account, there is nothing to sell - it's already cash.
6. There is no capital appreciation, so no capital gains taxes, and we've paid taxes on the interest each year along the way. No taxes due.
7. We have $5441.05 to spend.
One more thing to note about this is we make no allowance for inflation - in reality, after inflation, this saver has probably lost purchasing power, even though he diligently allowed his savings to compound for 25 years.
Let's do this same exercise with the purchase of some stock. We will buy just one single company, assume no commissions on the purchase and sale, assume the stock throws off a taxable dividend of 2%/yr (current div yld. of S&P500), further, we will assume that the dividend is reinvested with no commissions, and that the dividend and the stock price both grow together at 7%/yr. This is pretty close to the long-term returns of the S&P500, though note that it ignores volatility - it's not like the real thing clocks in that return year-after-year. In real life, it's gone up and down a lot. This is a very rough, back-of-the-envelope assumption made only for the sake of demonstrating some tax issues. One more thing, we're going to use 2010 tax rates. In 2011, assuming Congress doesn't change things, they are quite different - in 2011, some brackets go up, and the tax rates on dividends go back to being the same as your normal income taxes, rather than lower as they are now.
1. Earn money: $5000
2. Pay taxes: $3750
3. Invest in stocks: $3750
4. After a year, our stock has grown in value to $4012.50, and it's thrown off a taxable dividend of $75. We pay income taxes (at 2010 rates, that's 15% on most stock dividends) on that dividend, leaving us with $63.75 cash to reinvest in that stock. We buy more stock with that cash, so now we have $4076 worth of stock and a cost basis of $3813.75 (the after-tax amount we spent on the stock = the original $3750 + 63.75).
We'll repeat this process 25 times on a spreadsheet. The result is stock worth $30,183 with a cost basis of $8915.
5. We sell that stock for $30,183 of which $21,268 is a capital gain and $8,915 is a return of our cost basis.
6. Pay taxes on the gain: $21,268 is taxed at 15% ($3190)
7. We have $26,993 to spend.
Now, that's an astonishingly larger amount at the end of 25 years than one had in a savings account. The lesson here, however, is not that you should just buy lots of stocks - there are other considerations such as volatility and risk to consider. This was just to demonstrate how the taxes drag on the investment. For a much more apples-to-apples comparison, suppose that instead of paying a 2% dividend, the stock was a pure growth stock and paid no dividend. We'll assume the same overall theoretical stock return -- we'll assume that the stock price grows at 9% (in the previous example, the stock price grew by 7% and paid a dividend of 2%, so the total return is the same 9%). This will show the impact of those taxes you pay along the way on those dividends:
1. Earn money: $5000
2. Pay taxes: $3750
3. Invest in stocks: $3750
4. After a year, our stock has thrown off no taxable dividend, so we pay no taxes. The stock price goes up by 9%, so now we have $4088 worth of the stock, and since we didn't get a dividend to re-invest, we made no new purchase and our cost basis remains the same $3750 from our original stock purchase.
We'll repeat this process 25 times on a spreadsheet. The result is stock worth $32,337 with a cost basis of $3750.
5. We sell that stock for $32,337, of which $28,586 is a taxable capital gain, and $3750 is the return of our cost basis
6. Pay taxes on the gain: $25671 is taxed at 15% ($4288)
7. We have $28,049 to spend.
You can see that the effect of paying taxes along the way before re-investing those dividends has a substantial drag on the end result. Note further that in this example, those dividends were taxed at the same low rate as capital gains. They haven't always been taxed at the same rate. In 2011, unless Congress does something about it, the dividends will be taxed at a higher rate than cap-gains, and the advantage of not paying taxes on dividends along the way is even more powerful.
Let's run this same example with a high-dividend paying stock, with the same total return of 9%. This time, the stock pays a 4% dividend, and the share price grows by 5%/yr:
1. Earn money: $5000
2. Pay taxes: $3750
3. Invest in stocks: $3750
4. After a year, our stock has grown in value to $3937.50, and it's thrown off a taxable dividend of $150. We pay income taxes (at 2010 rates, that's 15%) on that dividend, leaving us with $127.50 cash to reinvest in that stock. We buy more stock with that cash, so now we have $4065 worth of stock and a cost basis of $3877.50.
We'll repeat this process 25 times on a spreadsheet. The result is stock worth $28,168 with a cost basis of $13,634.
5. We sell that stock - our gain is $19,098.98, and we get our $8,006 basis back.
6. Pay taxes on the gain: $14,535 is taxed at 15% ($2180)
7. We have $25,988 to spend.
The difference between a tax-efficient stock which throws off no dividends and a stock with precisely the same pre-tax total return but which throws off substantial dividends is quite large. On an original investment of $3750, the difference after 25 years is more than $2000. Tax efficiency is important!
To whet your appetite for our discussion of traditional and Roth IRAs, without going into all the details here, here are the results of taking that $5000 that we've earned and investing it in that same stock in a traditional and in a Roth IRA. We are sticking with the same assumptions: 9% total return on the stock (note that now it makes no difference whatsoever whether it pays dividends or not - since we don't pay any taxes along the way in either Roth or traditional IRAs), 25% income tax rate:
Traditional IRA: We end up with $32,337 to spend.
Roth IRA: We also end up with $32,337 to spend.
Note two things: (1) with the given assumptions, you end up with precisely the same amount of money to spend; and (2) it's more than with the taxable account regardless of the tax-efficiency (i.e.. the dividends paid along the way) of the investment.
We'll delve deeper into traditional IRAs, Roth IRAs and non-deductible IRAs in another article soon. Then we'll be ready to talk about IRA conversions.
Thanks for following along. As always, we'd love to hear from you with comments, criticism or questions.