roth ira vs. traditional ira

Investment Strategies for Tax-Advantaged Accounts

Chapter 45Tools & Techniques of

Investment Planning

Copyright 2007, The National Underwriter Company 1

Roth IRA vs. Traditional IRA

• Deduction of Contributions– Deductible contributions can be made to traditional IRAs.– Nondeductible contributions can be made to either traditional

IRAs or Roth IRAs. • Subject to phaseout based on adjusted gross income.

• Earnings in an IRA accumulate without any current taxation.



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• The tax rules for distributions from a Roth IRA are more favorable than those from a traditional IRA.– Qualified distributions from a Roth IRA can be received tax free.

• Include distributions received after age 59 ½ or death, on account of disability, or for certain first-time home purchases.

– Non-qualified distributions from a Roth IRA are generally treated as made from contributions first.

• Contributions received tax free

• Distributions from a traditional IRA are taxable except to the extent of nondeductible contributions – Distributions from a traditional RA are treated as made from

earnings and contributions on a pro-rate basis.



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• Nondeductible v. Nondeductible– Since the tax rules for distributions from a Roth IRA are more

favorable than those from a traditional IRA, it is better to make nondeductible contributions to a Roth IRA, rather than nondeductible contributions to a traditional IRA.



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• Deductible v. Nondeductible– Where tax equivalent amounts are contributed to a traditional

IRA on a deductible basis or to a Roth IRA on a nondeductible basis and the tax rates stay the same from the time of contribution to the time of distribution, both IRAs provide similar results.

• Where the taxpayer contributes tax equivalent amounts to a traditional IRA on a deductible basis or to a Roth IRA on a nondeductible basis and the tax rates go down from the time of contribution to the time of distribution, the traditional IRA produces the better result.

• Where the taxpayer contributes tax equivalent amounts to a traditional IRA on a deductible basis or to a Roth IRA on a nondeductible basis and the tax rates go up from the time of contribution to the time of distribution, the Roth IRA generally produces the better result.



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Converting Traditional IRA to Roth IRA

• A traditional IRA can be rolled over or converted to a Roth IRA in a taxable event.– For tax years before 2010, the conversion cannot be made if the

taxpayer’s adjusted gross income exceeds $100,000 for the year, or if the individual is married and files a separate return.

– A person making this conversion is trading the immediate taxation of the traditional IRA for the future favorable taxation of the Roth IRA.

• A person converting a traditional IRA to a Roth IRA can pay the tax on conversion from inside the traditional IRA or outside the IRA.– It generally makes sense to pay the tax from outside the traditional IRA.

• The payment of taxes from inside the IRA reduces the amount in the IRA.



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Other IRAs and Qualified Plans

• Deductible or excludable contributions may also be made to:– SEP IRAs– SIMPLE IRAs– Qualified plans– Tax-sheltered annuities, and– Eligible IRC Section 457 government plans.

• The taxation for these plans generally follows that for a traditional IRA.

• Employers can make matching contributions to certain plans.– The employee contributes to the plan on a deductible/excludable basis.– The employer matches part or all of the employee’s contribution, also on

a deductible/excludable basis.



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Measuring the Effects of Tax Leverage

• Comparing Alternative Investments– Equity investments

• Tax leveraged because the tax on gains is deferred until gains are realized.

– The realized long-term gains are generally taxed at a lower rate than ordinary investment income or interest.

– Qualifying dividends themselves currently become a tax preferred form of income, generally taxed at a maximum rate of 15%.

– After tax contribution to a commercial annuity• Complete tax deferral on investment earnings

• All earnings are ultimately taxed at ordinary income tax rates



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Implications and Conclusions

• Fully tax deductible, fully tax deferred vehicles still the best after tax– The fully deductible, fully tax deferred IRC Section 401(k)-

type investment is superior to all other accumulation vehicles, except the Roth IRA investment.

• Absent any tax penalties for early withdrawals or any change in tax rates



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• Fully tax deductible, fully tax deferred vehicles still the best after tax– The after-tax accumulation for the IRC Section 401(k)

investment and the Roth IRA investment are equal for every investment horizon.

• If the investor’s tax rate on ordinary income remains the same throughout the investment horizon.

• The amount by which the IRC Section 401(k) and Roth IRA investment outperform the others increases significantly with the length of the investment horizon.

– The qualified type plans where contributions are tax deductible and returns are entirely tax deferred generally are still the better investment.



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• Stock investments under old and new tax rule– A stock fund investment outperforms the fully taxable

investment as the investment horizon lengthens.

• Stock investments versus annuity investments– For longer investment horizons, the nondeductible, fully tax

deferred commercial annuity type of investment outperforms the stock fund investment.

• For shorter accumulation periods, the stock fund type is superior after tax

• Crossing point = 76 years



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Which Assets Should Be in Retirement Plans?

• The Issue– Typically, a well-diversified and properly managed portfolio of

investments will include some allocation of funds in a variety of asset classes.

• Domestic and foreign stock

• Large- and small-capitalization stock, value and growth stocks, foreign and domestic bonds, short- and long-term bonds, real estate, commodities, collectibles, etc.



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Which Assets Should Be in Retirement Plans?

• The Issue– Conventional wisdom suggests that it is best to acquire the

currently taxable income-generating assets, such as bonds, first within qualified plans and IRAs because this income will be sheltered from current taxation within the plan.

• A large portion of the return on growth-oriented investments, such as stocks and stock mutual funds, is already sheltered, since the gains are not generally recognized and taxed until the assets are sold.

• Deductible Contributions– The investor should invest plan dollars first in income investment.

• Supported by assumptions• Many variables determine best strategy



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Distributions of Employer Securities With Net Unrealized Appreciation• Overview

– The gain on employer securities with net unrealized appreciation is excluded when computing tax on lump-sum distributions

• Net Unrealized Appreciation (NUA)– The difference between the value of the stock when credited to the

participant’s account and its fair market value on the date of the distribution

– Typically arises with stock bonus plans and employee stock ownership plans.



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Distributions of Employer Securities With Net Unrealized Appreciation• Taxation

– Unrealized appreciation is taxed as long-term capital gain even if the participant sells the securities immediately after distribution.

• Currently, the gains on most investment assets held for more than 12 months are taxed at a rate of 15%.

• Under Notice 98-24, any amount of net unrealized appreciation (excluding amounts included in the recipient’s basis at the time of the distribution) that occurred while the plan held the securities will be treated as long-term gain.

– Subject to the 15% rate when it is ultimately realized in a subsequent taxable transaction.

• For appreciation that occurs after the plan distributes the securities, the actual period the recipient held the securities after the distribution determines whether the long-term gain rate applies to that portion of gain.



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Distributions of Employer Securities With Net Unrealized Appreciation• Planning

– Only if the participate anticipates an immediate sale of the securities and intends to elect lump-sum-averaging tax treatment, might it be better to have the trustee sell stock and distribute cash.

• The proceeds will be included in and benefit from lump-sum averaging calculation.

• Most unrealized appreciation on employer stock is currently taxed at a maximum rate of 15%.

– Adjusted total taxable amount in excess of $30,583 is subject to tax at a rate in excess of 15%.

• It will only pay to have the trustee sell the stocks and distribute cash if the value of the stocks and cash distributions does not exceed $30,583 in total.

roth ira vs. traditional ira

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