Roth IRA – Long Benefit Explanation from LinkedIn

Tax refund:  A tactic devised by politicians to give you back some of your own money in such a way that you are supposed to think it’s a gift. (from http://www.businessdictionary.com/)

I privately answered a LinkedIn member’s question regarding the advantages of the Roth IRA (well since he is Canadian, the new “Canadian Roth”). He was of the opinion that it was not advantageous to do because of the low limits and that the current deduction was more of a benefit.

I argued that it depends if your thesis for the future includes increasing taxes, decreasing taxes, or no changes. The tax code effectively makes the Roth “tax neutral” if assumed tax rates don’t change.  See my full answer below (understand that I do not provide tax advice – I am merely crunching some numbers here – OF COURSE consult your own tax advisor before making any plans or changes to your plan – this is not the be all/end all answer for everyone!):

Christopher Grande, MSIM wrote:Hi XXXXXX,

yes on its face, it would seem taking the deduction makes more sense and yes for wealthy people, it might be a moot point -but let me bring up 2 analyses (one simple one complex):Simple analysis – now remember, the US govt and Canadian govt are in two different positions. The US, a consumption whore of a nation will continue to debase its currency and overspend to avoid recession – taxes will surely rise. Canada on the other hand, has a decade+ of strong natural resource exportation lined up. Your country should easily balance budgets.That being said, I could simply advise use of a tax free account to ‘diversify’ your tax risk (if you’re wealthy).

 

The more complex analysis – I have run a spreadsheet on this but the US IRS already has shown that the Roth IRA here is meant to be tax revenue neutral. Basically, if you compare putting $5,000 into each plan, taking the tax savings and investing that IN ADDITION to the 5,000, and compare that to the tax free account, assuming tax rates don’t change, then you could withdraw after taxes the same amount from each strategy in the future assuming the same growth rate.

 

The difference for us at least here in the USA is this: if you invest $5,000 per year, and you are 28 years old and invest until age 68, earning 8% growth, you would have a little over $1.4M according to my calcs. And then with the tax savings of 25% of that, the savings would grow to 25% more say deferred in an annuity.

 Where it kicks in though, is say at age 68 you decide you want to invest in one of your cool income trusts (I know about the tax code changes but still – let’s say an MLP in the USA) and it pays out 9%. What if the new tax rate on savers is 40% in the future? Now you pay more taxes on the way out with the deferred account but you have eliminated the tax risk with the tax free account – and I for one would rather eliminate a risk than to defer or mitigate it, don’t you agree?

 

So now your client is collecting 9% or about $126,000/year tax free. In the other example the client is paying 40% taxes on an income about 25% higher (about 157k adding the deferred annuity) and with taxes at about 63,000 on that, the client’s take home is just under 95,000.

 My thesis is the US tax rate is much higher in the future – perhaps your thesis for Canadian taxes is lower, and I would probably agree with you but I simply don’t trust government. officials are basically a bunch of people who studied english then got law degrees and now they want to ‘control’ a market in the global economy. these people are not to be trusted – hence, tax free works for us – and we also have Roth 401k, SEP’s etc now allowing higher annual contributions (over 16k).

 Thanks,

 Chris

 On 01/06/09 8:03 AM, XXXXXXXXX  wrote:
——————–
No doubt almost everyone would benefit from the TFSA (like the Roth IRA). But the question is, how much will they really benefit?

 

The contribution limit is $5K a year. So if you are wealthy, you are looking for stategies to shelter a lot more than $5K a year. If you are not wealthy, you may not have enough after-tax income to put away into the TFSA after paying your living expenses. And if you are not wealthy, your RRSP (like a 401K) is probably under funded as well.

 

If you earn 5% on the $5000, then the interest earned is $250. At the highest marginal tax rate , that’s $115.00 of taxes payable. But at a 25% *effective* tax rate, that’s only $62.50 of taxes payable. Wow!

 

All in all, its seems a little more political for the government to introduce the TFSA as it gives the perception that the government wants Canadians to pay less tax. In reality, more people would benefit from a reduction in personal income taxes, especially those not as fortunate.

 

On 01/05/09 4:41 PM, Christopher Grande, MSIM wrote:
——————–
Hi XXXXX,

 

I can only answer theoretically since I am not familiar with the language of the law but if it is similar to the Roth IRA, I would investigate it because it reduces future tax risk from planning.

 

Perhaps Canada will be different, but I am of the belief that a government with the power to tax will usually look for ways to increase taxes – this could be one of the few ways to guarantee no taxes. If I’m off-base here let me know…

 

Chris

 

Question Details:
——————–
What are your opinions on the new Tax Free Savings Account (TFSA)?

 

The Canadian government introduced the legislation last year, and the TFSA officially starts January 1, 2009.

 

I have my own opinions located at http://pgfinancial.ca/cgi-bin/ebb/blog2/index.php?action=viewcomments&pid=9

 

But will *you* contribute into it? Why or Why not?

  • There are several acotrs with the TIPRA changes for 2010 that people should consider in addition to Chris’ tax rate comments.

    1.) What do expect your average rate of return to be in the period until you die.

    2.) The legislation gives you a 3 year window to pay the tax on the conversion amount. Factor in up to 3 years of returns against the taxes you pay.

    3.) What if you were able to invest into a hard asset, like rental property? Imagine the tax-free income and benefits to your heirs. Plus, the rental property could be distributed tax-free and lived in or used for deductions.

    Thsi topic is facinating. I’d like to see Chris do more with it.

    Chris?

  • Whoops, that should be ‘factors.’

  • Hi Rob,

    I am certainly a big fan of the Roth IRA and plan to take advantage of the conversion features. I already have plans for clients to convert some assets to the Roth and recommend the Roth SEP and 401(k) options also.

    Of course each person reading this should consult their tax advisor since I am not giving advice on this post but it’s worth checking in to…