For Your Information
At Last, A Gift from Your Congress!
As I've mentioned in another article in the ITS: FYI pages, a favorite American pastime, (though not a happy one), is to play "The Blame Game." Probably our most cherished target for laying blame on-for nearly everything that goes wrong-is the President of the country. Doesn't make any difference which political party the standing President is aligned with, somewhere during his tenure in office he's going to get hammered in the printed press, television press, and by a whole lot of citizens over morning coffee, after work drinks in the pub, and at backyard barbeques on Saturday evening -maybe even during MOST of his tenure in office.
The second favorite target for blaming among Americans is our Congress, duly elected by us and expected to have our collective best interest in mind while putting forward and passing legislation. Certainly both the President and Congress highly deserve our ire at times, especially (in my view) for the way they can't seem to manage the National Budget and the fast and loose way they seem to deal with the tax money we pay for the common good of this country. I'm pretty sure I wouldn't want any of those guys to be in charge of my family check book, let alone my investment program.
But, TAKE HEART. Not all is as bleak as it appears to be sometimes. Your Congress, and the then in-office President, created a really wonderful bit of law for our collective benefit and future financial well being. It's the Roth IRA.
Now, practically everyone is familiar with IRAs-another good thing Congress did for us-because they've been around a long time. The Roth IRA may not be as familiar, at least to the people I seem to talk with, but it has a really significant advantage over a regular IRA in terms of federal taxes.
Both a regular IRA and a Roth IRA have tax advantages when compared to non-IRA investments. With a regular IRA, you contribute regularly to a qualified Individual Retirement Plan with pre-tax dollars and then pay taxes when you begin drawing out the money later at your retirement. With a Roth IRA you contribute after-tax dollars and you will owe no further taxes on the contributed money or on the money that grows from it if you leave the money in the plan for at least five years. The taxes have already been paid.
So let's do a little calculation to see which has the MOST advantage to you in terms of taxes and the money left for you to enjoy a way-cool retirement. This calculation in simplified and omits details that might affect any one person's financial situation, but it will give a fine overview of the difference between the two options.
Say you're 22 years old, just starting your career, and you're wise enough to begin preparing for you long term future right now. You invest $200 per month in a Roth IRA, and you keep doing that until you're 72 years old at which point you MUST begin drawing out the money. Your best friend elects to put in the same amount as you do over the same time span, but uses a regular IRA instead of a Roth.
For this study, we'll assume you both invest in the same equity indexed fund and get an average return of 10% a year over the fifty years, which is the historic return from common stocks over the last hundred years.
Who will do better?
Doing a "future value" calculation using $2400 per year for fifty years at 10% return shows us that you both will have grown your investments to $2,793,000 dollars.
Your friend hasn't paid taxes on the money yet and will have to pay as he or she draws the money from the account. Assuming all the money will be withdrawn over a span of ten years (to age 82) means your friend will take $279,300 each year. Assuming a 25% federal tax rate at the time, he or she will pay $69,825 each year leaving a very nice $209,475 for beer, pretzels, and traveling to see grandchildren. Over the ten years, your friend will pay $698,250 to the Internal Revenue Service.
You, on the other hand, have paid your taxes every year. Assuming the same 25% tax rate, you would've paid $800 in taxes each year and would've needed to earn $3200 pre tax dollars to free the $2400 for your Roth IRA. ($2400 is 75% of $3200). So, your tax burden will have been $800 per year for fifty years totaling $40,000. Because you've already paid your federal taxes and the law doesn't permit taxing the money twice, you'll have $279,300 to buy beer, pretzels, and visit grandchildren every year. The whole $2,793,000 will be available to you, and you're nearly a million dollars to the good in this little long-term competition between you and your buddy.
WAY TO GO, you clever person you.
Now here's something to think about. Current law lets you invest up to $5000 in a Roth IRA. What would happen if you did that? Well, instead of two million seven hundred ninety three thousand dollars, you'd have FIVE MILLION EIGHT HUNDRED NINTEEN THOUSAND FIVE HUNDRED FORTY THREE dollars for beer, pretzels, wine, caviar, trips to see grandchildren, trips to wherever in the world you've been itching to go.
Wouldn't that be nice?