Monday, July 23, 2012

Thoughts on IRAs and 401k's for high income individuals, Part 3

Having written two posts about the relative pros and cons of IRA, Roth IRA, 401k and Roth 401k, in this post, I will try to give a somewhat comprehensive summary.

IRANon-deductible IRARoth IRA401kRoth 401k
Contribution limit5k5k5k17k17k
Income phase out start56kN/A110kN/AN/A
Income cap66kN/A120kN/AN/A
Withdrawal Tax after 59.5EntirityEarning onlyFreeEntirityFree
Early withdrawal penalty
(In addition to normal tax)
10%10% on earningFree after 5 years10%10% pro-rata

Personally, I'd maximize the Roth options of both as they are more flexible when it comes to early withdrawal, and they effectively increase the amount of money that you have which is tax-free! A simple calculation for maximizing IRAs that assumes 8% annual return, 30 years time frame, 28% federal tax and 2% state tax shows the following result:

Contribution (after tax)105000 (After tax equivalent)150000
Ending balance566416 + (150000-105000) = 611416566416
Tax due566416 * 0.3 = 169924.80
Total after tax441491.2566416
The traditional IRA's total asset after 30 years plus the sum of tax savings every year is only about 78% of the Roth IRA's total asset.
The situation is similar for 401k and Roth 401k.

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