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26 May 2018

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.

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Jean Keeling
Jean KeelingLv2
29 May 2018

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Yuki (age 45 at year-end) has been contributing to a traditional IRA for years (all deductible contributions), and her IRA is now worth $38,000. She is trying to decide whether she should roll over her traditional IRA into a Roth IRA. Her current marginal tax rate is 25 percent. She plans to withdraw the entire balance of the account in 20 years and she expects to earn a before-tax rate of return of 4.8 percent on her retirement accounts and a 3.8 percent after-tax rate of return on all investments outside of her retirement accounts. For each of the following alternative scenarios, indicate how much more or less Yuki will accumulate after taxes in 20 years if she rolls over her traditional IRA into a Roth IRA. Be sure to include the opportunity cost of having to pay taxes on the rollover. (Round "Future value factor" to 4 decimal places. Round final answers to the nearest whole dollar amount.)

a. When she withdraws the retirement funds in 20 years, she expects her marginal tax rate to be 35 percent.

b. When she withdraws the retirement funds in 20 years, she expects her marginal tax rate to be 20 percent.

c. Assume the same facts as in part (b), except that she earns a 2.8 percent after-tax rate of return on investments outside of the retirement accounts.

A Roth IRA enables an individual to invest after-tax dollars during the accumulation phase of a retirement plan. The money is then income tax free when it is withdrawn during retirement. A tax-deductible IRA, on the other hand, provides an up-front tax deduction for the annual contribution, but it then requires income taxes to be paid on all future distributions. A basic assumption as to which plan is more beneficial concerns the current value income tax rates versus their projected rates in the future. Suppose that you plan to invest $4,000 at the end of each year for 30 years. Your current income tax rate now is 28%, so $4,000*(1-0.28) = $2,880 can be invested this year into the Roth IRA. However, the full $4,000 per year can be invested into a tax-deductible IRA. Money invested under either plan will be deposited into a mutual fund earning 8% per year. (A) Develop a spreadsheet to determine which IRA will be the better investment. (B) Assuming you will turn 65 in 30 years, examine your projected income and tax rate and develop an investment and retirement withdrawal strategy.

Kathleen, age 56, works for MH, Inc. in Dallas, Texas. Kathleen contributes to a Roth 401k and MH contributes to a traditional 401k on her behalf. Kathleen has contributed $22,500 to her Roth 401k over the past six years. The current balance in the Roth 401k account is $37,500 and the balance in her traditional 401k is $26,250. Kathleen needs cash because she is taking a month of vacation to travel the world. Answer the following questions relating to distributions from Kathleen's retirement accounts assuming her marginal tax rate for ordinary income is 28%.

A) If Kathleen receives a $3,750 distribution from her traditional 401k account, how much will she be able to keep after paying taxes and penalties, if any, on the distribution?

B) If Kathleen receives a $3,750 distribution from her Roth 401k account, how much will she be able to keep after paying taxes and penalties, if any, on the distribution?

C) If Kathleen retires from MH and the she receives a $3,750 distribution from her traditional 401k account, how much will she be able to keep after paying taxes and penalties, if any, on the distribution?

D) If Kathleen retires from MH and the she receives a $3,750 distribution from her Roth 401k account, how much will she be able to keep after paying taxes and penalties, if any, on the distribution?

E) Assume the original facts except that Kathleen is 60 years of age, not 56. If Kathleen receives a $3,750 distribution from her Roth 401k (without retiring), how much will she be able to keep after paying taxes and penalties, if any, on the distribution?

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