BSAD 282: Security Valuation and Portfolio Selection



BSAD 282: Security Valuation and Portfolio Selection

Project 1: IRAs - Traditional vs. Roth

The following article was retrieved from .

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By David Wolpe

Of course it's true that there are 11 types, but the two we hear the most about are the traditional IRA and the Roth IRA. What, in a nutshell, is the difference? Well, here's the nutshell.

Traditional IRAs

The tax breaks for a traditional IRA are of the "this is tax-deductible" kind. That means that … the money you deposit in your IRA isn't taxed. And regardless, whatever earnings you have on your contributions won't be taxed until you withdraw that money many years later.

For example, let's say you made $30,000 during the year, and you put $2,000 of it into an IRA. You would pay income tax on only $28,000. Additionally, your deposit will grow free of tax through the years. When you finally withdraw the money for your retirement -- after age 59 1/2 -- then, and only then, will the money be taxed as income at your ordinary income tax rate.

The Roth IRA

The tax breaks for a Roth IRA are different. Unlike a contribution to a traditional IRA, a Roth IRA contribution is never deductible. Taking the above example, you'd still be taxed on $30,000 even though you had put the same $2,000 into a Roth IRA. However, when you withdraw the money from a Roth IRA, none of it -- and that includes the earnings -- will be taxed, assuming that the Roth IRA has been open for at least five tax-years and you are older than age 59 1/2. That's right -- you get off scot-free with the booty. All you have to do is to wait until you can withdraw it penalty-free. Again, that's after age 59 1/2, and as long as it's been in there for at least five years.

In other words, the Roth offers tax-exempt rather than simply tax-deferred savings. One word makes a big difference.

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Tasks:

Suppose that you work for a financial planning company. You are asked to write an article that will be used to educate the company’s customers about whether they should contribute to a traditional or Roth IRA. Suppose that the article targets a typical customer who contributes $4,000 every year. The contributed monies in both a traditional IRA and a Roth IRA can earn 6% every year. The typical customer will retire at age 65. The effective capital gain tax rate is assumed to be 15% at the time when the typical customer retires. The marginal income tax rate for the typical customer is assumed to be 20% now and is expected to remain constant over time. And you must consider clients aged 30 to 60. Be sure to address the following issues in your article:

1. Why is it important to make such a comparison?

2. What measure do you use to evaluate the two IRA options? Why the measure is economically sensible?

3. Does age play a role? And, how? Is there a critical age at which the better choice switches?

Submit your typed article and a separately attached (Excel) calculation in a week. Note that this is an individual assignment. In addition, this is an article that will be mailed to the company’s customers. So you want to make sure that the article looks attractive and inviting.

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