Gloomy Weeks…Plan Ahead

Today I want to talk about a conversation I had with my aunt recently. She was explaining to me how she became broke for awhile because she didn’t really plan longterm. I’m speaking with regards to pension plans, 401k retirement plans, and Individual Retirement Accounts or IRA’s. I was really getting schooled on alot of stuff and learned many things. Some advice. For those individuals working already, or getting ready to join the workforce here’s some cool and interesting information.

First off, when or if you’re going to open a retirement account, go with the Roth IRA. It has many benefits which I’ll explain later. This should be the FIRST thing you do. Don’t wait for your crappy job to have you wait a year to determine whether you qualify for a 401k. I mean its really stupid that they do that to begin with but I don’t wanna get into it. Go to your bank and just request an IRA. It’s pretty much the same thing.

So…why is the Roth IRA better then a normal IRA?

A $4000 contribution to a Roth-IRA growing at a constant (and riskless) rate of 10% will, in 25 years, grow to 4000 * 1.1²⁵ = $43,338.82. Because this $4000 contribution is not tax-deductible, the contribution plus the tax will cost 4000 / (1-.25) = $5333.33 in the year of contribution (i.e. the taxes on $5333.33 earned will be $1333.33, leaving $4000 to invest).

If $5333.33 is put into a conventional IRA, $4000 of this contribution will grow tax-deferred. This will grow to $43,338.82 in 25 years using the same assumptions and calculations above. The tax on this amount will be 25% * 43,338.82 = $10,834.71, leaving 43,338.82 - 10,834.71 = $32,504.12 from the IRA account. However, the investor will have 5333.33 - 4000 = $1333.33 left to invest in a “naked” (i.e. taxable) account. Taxed every year, this amount will grow to 1333.33 * (1 + .1 * [1-.25])²⁵ = $8131.12. This implies a total, after-tax amount of 32,504.12 + 8131.12 = $40,635.24.

Explanation. The Roth IRA is better because withdrawals of earnings are tax-free. (After 25 years earnings are $43.338.82. However taxes are paid only on $5333.33)

Another reason is that the $1333.33 tax savings in the year of the contribution cannot grow in a tax-deferred account. If this amount were able to grow in a tax-deferred account, then the $1333.33 would grow to 1333.33 * 1.1²⁵ = $14,446.27, and if taxed at 25% upon withdrawal would imply 14,446.27 * .25 = $3611.57 in taxes, leaving 14,446.27 - 3611.57 = $10,834.71. Adding this to the $32,504.12 amount from the Traditional IRA savings equals 32,504.12 + 10,834.71 = $43,338.82, just like in the Roth IRA. Since the maximum IRA contribution is imposed after taxes are paid for Roth-IRA contributions, there is effectively a tax-deferral advantage for Roth contributions when, and only when, an individual is making the maximum contribution allowed.

Now, just think if you combine that with your 401k plan. I mean chances are you’re going to be getting raises at your job and considering the fact that your plans tend to rollover so it doesn’t really matter where you work…Roth IRA is the way to go.

It’s been raining alot lately where I live. I kind of like the rain but I like it even more when my windshield wipers in my car work. Anyways, I was gonna write a little spiel on my experience with doing grass roots campaign work for the Obama campaign a few months back, but I don’t want to beat a dead horse. I’ll talk about that on Wednesday. And yes, I will be addressing many of you fake folks out there who love Obama but do absolutely nothing to help out on his campaign. (Don’t worry not talkin about you Rev…just citing some recent friends I’ve encountered/met from around the way.) I’ll talk about that on Wednesday.

Later fiends!