Roth IRA Contributions

KaitelanKaitelan Posts: 139Member
edited May 2013 in Personal Finance
Can anyone please explain to me how Roth IRA contributions work?

I've gone out to Betterment and created an account and selected a Roth IRA. The Auto-deposit want's me to set up a $808.06 monthly deposit. Or an Annual deposit all at once of $9696.72. They claim this maximizes 2013 contributions and I wouldn't be asked for more until 2014. It appears they're going from 15 Apr 2013 to 14 Apr 2014 for their year.

Max contribution is $5,500 plus $1,000. I took that 10-day investment course, and I know Jesse said you can make more contributions but I still don't get it, even after reading it twice. Where does the additional $3,196.72 come from?

I've tried researching the contribution rules on the IRS and other financial sites and it's all very confusing. I want to be sure I'm not doing something illegal or unethical or whatever. I haven't given them any funds yet, I'm still waiting for the link to my checking account to be setup.

And yes I have the funds available. I started with $160K in my checking and I front-loaded my Investments category with $30K for future use. Well, the future is now.
Post edited by Unknown User on

Comments

  • wedjan245wedjan245 Posts: 1,049Member
    As far as I know, 2013 max contribution is $5500. Since the contribution can spread to the April 15 next year, in any year, one can contribute using last year's unused quota. For example, if you didn't max 2012 contribution, the amount you contribued between 1/1/2013 and 4/15/2013 can be counted as 2012 contribution until last year's $5000 is reached.

    EDIT: Since you use betterment's goal based system, is it because you set a goal and the deposit is calculated based on your goal rather than your income and age?
  • KaitelanKaitelan Posts: 139Member
    wedjan245 wrote:
    EDIT: Since you use betterment's goal based system, is it because you set a goal and the deposit is calculated based on your goal rather than your income and age?

    Well, the goal is $250,000 at retirement which I know is unrealistic because I'm 60 years old and I'm going to be retiring when I'm 68. I don't really understand what the deposit is calculated on.

    I'm beginning to wonder if a ROTH IRA is the best idea. I mean, if I put $6500 in it up front, that's it for 2013, right? And then I get taxed on it? When it isn't income? I mean this is money I had in my checking account five years ago. I paid taxes when it was income. Why do I pay now? I just don't get it. I try to read about this stuff and my eyes glaze over.

    Shoot, maybe the best investment I could make right now is a $1 lottery ticket every week. :roll:
  • JoelJoel Posts: 9,738Member, Beta Tester, Beta Moderator
    Your Roth IRA dollars will not be taxed again.

    If you contribute to a traditional Ira it would reduce your taxable income now, and the money would be taxed later.

    You absolutely should maximize your Roth IRA every year going forward.

    If you have a 401k at work, you should contribute to that. If not, you should try to save money in a taxable brokerage account.
  • wedjan245wedjan245 Posts: 1,049Member
    Joel wrote:
    Your Roth IRA dollars will not be taxed again.

    If you contribute to a traditional Ira it would reduce your taxable income now, and the money would be taxed later.

    Very clear explaination.

    Here is an example:

    Assume your tax bracket is 28% now and 25% after retirement, you pay 28% tax with ROTH and 25% with 401k.

    If you contribute $5000 to ROTH and it grows to $20000 after 20 years, no more tax, you get all $20000.

    If you contribute to 401k, $5000 after tax equals $6944 ($1944 to Uncle Sam) before tax at tax rate 28%. So $6944 grows to $27777 before tax. When you retire, you pay 25% tax (lower total income, increased tax bracket threshold ...), you will get 27777*(1-0.25)=$20832 after tax.

    The above showed tax deffered account is better when your tax rate is lower after retirement, which is true for most people. That being said, you can shop around for ROTH, but stuck with employer's 401k. If the fund selection and fees are not good in 401k, ROTH bcomes more attractive.

    It is also possible to contribute to traditional IRA in addition to employer's 401K. From what I heard, it is complicated to file tax in that case. I would like to hear if anyone has done that.
  • bradbrad Posts: 3,115Member
    wedjan245 wrote:
    If you contribute $5000 to ROTH and it grows to $20000 after 20 years, no more tax, you get all $20000.

    If you contribute to 401k, $5000 after tax equals $6944 ($1944 to Uncle Sam) before tax at tax rate 28%. So $6944 grows to $27777 before tax. When you retire, you pay 25% tax (lower total income, increased tax bracket threshold ...), you will get 27777*(1-0.25)=$20832 after tax.

    I've seen this argument many times and it makes perfect sense from a logical bottom-line perspective. But I'd argue that it applies to relatively few people in real life, because it assumes that people will invest the tax refund from their traditional IRA so their annual contribution will be higher. How many people take the time to figure out the portion of their refund that's attributable to their traditional IRA contribution and then put all of that refund toward next year's contribution? My guess is not many, especially if they can't add the refund to their contribution because they're already at the contribution limit for the year.

    If person A has a traditional IRA and person B has a Roth IRA and they each contribute the exact same amount each year, person B will end up richer in the end because the growth is untaxed; they're only taxed on their initial contributions. If person A and person B each contribute 5,000/year for 20 years ($100,000 total) and the investment grows to $500,000, person A will have to pay tax on $500,000 at retirement while person B will only have paid taxes on the initial $100,000 in contributions. Regardless of your tax rate, having $400,000 of tax-free income is a better situation, plus it gives you more certainty in your ability to plan for your retirement since you don't have to worry about future tax rates or factor taxes into your calculations.

    My hunch is that most people don't adjust their contribution to their retirement based on whether their contribution is taxed or not; they set a goal and work toward it; when their refund comes in, some of it may go to their retirement but much of it may go to other priorities (debt reduction, vacation, shopping sprees, etc.). I feel like this is more of a real-life comparison than the hypothetical one in which a person who contributes to a tax-deferred account reinvests the refund so their annual contribution is higher.
  • wedjan245wedjan245 Posts: 1,049Member
    brad wrote:
    wedjan245 wrote:
    If you contribute $5000 to ROTH and it grows to $20000 after 20 years, no more tax, you get all $20000.

    If you contribute to 401k, $5000 after tax equals $6944 ($1944 to Uncle Sam) before tax at tax rate 28%. So $6944 grows to $27777 before tax. When you retire, you pay 25% tax (lower total income, increased tax bracket threshold ...), you will get 27777*(1-0.25)=$20832 after tax.


    If person A has a traditional IRA and person B has a Roth IRA and they each contribute the exact same amount each year, person B will end up richer in the end because the growth is untaxed; they're only taxed on their initial contributions. If person A and person B each contribute 5,000/year for 20 years ($100,000 total) and the investment grows to $500,000, person A will have to pay tax on $500,000 at retirement while person B will only have paid taxes on the initial $100,000 in contributions. Regardless of your tax rate, having $400,000 of tax-free income is a better situation, plus it gives you more certainty in your ability to plan for your retirement since you don't have to worry about future tax rates or factor taxes into your calculations.

    No doubts B is richer if A contributes $5000 to traditional IRA while B contributes $5000 to ROTH IRA, but this comparison is not fair.

    For A, the $5,000 is before tax. In US, it means A asks employer to deduct $5,000 from his paycheck before tax, and his 401K will have $5000. If he decides to invest in ROTH, his employer won't deduct his paycheck, then he will have 5000*72% (assuming tax bracket 28%)=$3,600 more in his bank account. How could he contribute $5000 to ROTH if everything else is equal?

    In traditional IRA or 401K, it's like I am investing for my portion and IRS portion of money simutaneously, but the split is determined later by the tax rate at my retirement. In ROTH, I only invest my portion while IRS takes the other portion to do something else, and the split is determined my my current tax rate, which is higher to me and most people.
  • bradbrad Posts: 3,115Member
    Exactly, it's not a fair comparison, but I'd argue that it's a more realistic comparison. We don't live in an apples-to-apples world.

    I would leave 401(k) out of it; I think we're comparing traditional vs. Roth IRA per Joel's message above. My feeling is that at the beginning of the year, when planning their budget, people generally set a goal for their retirement contribution -- say, $5,000, regardless of whether it's taxed or not. They don't say, "I'll set aside $5,000 if I'm investing in a traditional IRA, but only $3,600 if I'm investing in a Roth because I won't get a tax refund." Usually they just set a goal and then strive to meet it. If they're really disciplined about meeting the goal, the tax refund they get from last year's IRA contribution might help them meet their goal, but my argument is that most people don't actually behave that way. When the refund comes in they often spend it on something else. Therefore in actual practice they end up investing the same amount regardless of whether they're investing in a Roth or a traditional IRA.

    It would be interesting to see if any studies have been done comparing the actual annual contributions of people with Roth IRAs vs. people with traditional IRAs to see if there's any difference, although it would be hard to do a truly controlled experiment (there may be other factors at play that could contribute to differences between the two).
  • YYC27YYC27 Posts: 1,968Member, Beta Tester
    brad wrote:
    They don't say, "I'll set aside $5,000 if I'm investing in a traditional IRA, but only $3,600 if I'm investing in a Roth because I won't get a tax refund."
    Well, I do .. :P

    My goal for retirement contributions is 10% of regular income + any matching from my employer, net of tax effects. I do try to make the majority of my RRSP contributions through payroll deduction so I don't have to wait for a refund.
  • bradbrad Posts: 3,115Member
    Well I did say "most people." ;-)

    I do think the employer match (for RRSPs in Canada or 401(k) in the States) makes the comparison more complex than if we're just talking traditional vs. Roth IRA.

    In theory the tax refund from a traditional IRA would make you more likely to be able to contribute more to your retirement than if you have a Roth IRA. But I don't think a lot of people behave that way.
  • MalisaMalisa Posts: 6,140Member, Moderator, YNAB Team, Beta Tester
    brad wrote:
    I've seen this argument many times and it makes perfect sense from a logical bottom-line perspective. But I'd argue that it applies to relatively few people in real life, because it assumes that people will invest the tax refund from their traditional IRA so their annual contribution will be higher. How many people take the time to figure out the portion of their refund that's attributable to their traditional IRA contribution and then put all of that refund toward next year's contribution? My guess is not many, especially if they can't add the refund to their contribution because they're already at the contribution limit for the year.

    Not exactly the same thing, but I balance out what I'll increase my 403b contribution by along with my withholding. Meaning when we got raises (not really raises, just that some furloughs ended) and I didn't want to see that increase in take home pay, and at the same time I was trying to increase my withholding so I don't owe as much as I did this year, I took into account that the more I put into my 403b (which has obvious other benefits) the less 'extra' withholding I have to have taken out.
  • Semirhage527Semirhage527 Posts: 1,382Member, Beta Tester
    brad said:
    . My feeling is that at the beginning of the year, when planning their budget, people generally set a goal for their retirement contribution -- say, $5,000, regardless of whether it's taxed or not. They don't say, "I'll set aside $5,000 if I'm investing in a traditional IRA, but only $3,600 if I'm investing in a Roth because I won't get a tax refund." Usually they just set a goal and then strive to meet it.

    This is certainly true for us.
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