Jump to content

Should I open a traditional IRA right now?


Guest ctfudge07
 Share

Recommended Posts

It is hard to find anything to say that hasn't already been said, but I shall try. ;-_

Also, I wanted to add my appreciation for ctfudge07's participation here on benefitslink. And, of course, to the other contributors in this educational thread.

You started out focusing on IRA's. But as it has developed, the discussion has highlighted how important one's entire financial picture is. One seemingly small detail can sway the recommended course of action dramatically. Focusing on whether you can save $1,200 in taxes this year and in each of the next few years may not be the right thing to focus on.

As long as you keep to some sound basic financial decisions such as not extending yourself, debtwise, beyond what you are comfortable handling, you should be fine whether you go with traditional IRA's or not.

With that said, it seems to me that a basic issue your family will be facing within a (too) short period of time is funding for college. In fact, I'd suggest it may be the fulcrum upon which the rest of your decisions might be based. Only your family can know the likelihood (how many of your children will go to college) and the expense anticipated (in-state, out-of-state, whether you and your husband believe in participating in the cost of college, etc.).

If you find that the institutions you think your children are likely to attend have favorable rules regarding grants and scholarships predicated on ignoring home equity (as has been discussed), it may be in your family's best interest to maximize your home equity at the expense of cash reserves. Of course, to do so blindly would not be prudent, but I will suggest that it may be the best course; that is if all other things fall into place nicely.

Those other things might include: 1) ensure your credit will allow you to establish a home equity line of credit (more about this below); 2) find a home that you believe you can add value to through improvements you can do yourself; 3) ensure your insurance is up to date and protects your family from financial ruin; 4) feel comfortable enough with the entire picture that you don't end up creating more anxiety than it is worth.

That last point is crucial. You've been through some painful times and you may therefore be a bit gunshy with respect to a plan that diminishes liquidity. If so, that is just fine and nobody should try to force such a strategy on you.

But if your family can deal with it emotionally, you might find that the potential additional scholarships/grants, coupled with the fact that the strategy I'm discussing might currently put you in a larger home than you might otherwise be thinking of can pay off in more ways than one.

Based on your thought process relative to the real estate professional you worked with, you seem to know the value of professional assistance. You might consider laying everything out with a trusted financial planner who can balance all of your personal details and emotional needs. Research your choice of professional, of course. For example, some papers run periodic analyses by local planners. You might be able to find somebody who has just the right kind of pencil sharpener for you.

Here are some other random thoughts.

One of the often overlooked tax breaks that we have is the rule that says once you have owned a home for two years any (reasonable) gain that you realize upon sale is tax free. There is a limit, but it is not likely to be reached in a two or three year period if you start with a value of between $240 and $400k. Would you and your family consider moving every two or three years to maximize or lock in the tax free gains that might be available?

Couple the above with the fact that the interest you pay on your home loan is deductible. Now go back to the example given earlier in the thread. You can see that your rate of return on home ownership is dramatic, even with a modest uptick in the value of the property. In fact, it dwarfs the tax savings you can get from your IRA's, even at relatively low income tax rates.

By the way, with respect to the home equity line of credit I mentioned, I did so based on the assumption that it would never, ever be accessed. That is, it is there as a safety net for staving off disaster, not for dipping into on a whim. Based on what you have said about your desire to remain debt free, I don't think you would be tempted to invade the line of credit without good reason, but I did want to point out that I wasn't thinking of it as a piggy bank.

Here's my basic point. If the $8,000 (actually $6,800 after taxes) makes the difference between you being able to comfortably enter the real estate market or not, I'd avoid the IRA's entirely and plan on putting that money to use on a down payment.

Nothing I've said means that you should scarf up the first home that becomes available. But if you put pencil to paper and find, in conjunction with a professional planner, that this concept has merit, I would think your focus would be to find that (currently distressed?) property. Which requires work, as you know.

Happy planning. I'm sure you will find a path that is right for you and that you are comfortable with.

Link to comment
Share on other sites

Guest ctfudge07

I appreciated your comment, John G, and it prompted me to get out the loan papers and find an amortization calculator specifically for car loans at Bankrate.com, and I scrutinized the issue for hours before figuring out that over the life of the loan, we'd pay 9,000 in interest for the car, we've already paid 2,000 (I'm rounding here) and after paying for one year at $450 per month, we've paid only about $200 in principal on the car... let's just say I crunched it out pretty well and compared it to other calculators involving investment amounts. I don't know why I didn't pursue a career in something involving math, because I really do like calculating and analyzing. But your comment was helpful, and it did inspire me to find several different calculators and tools that are really helpful for a variety of applications.

Mike Preston: I appreciate the time and effort you and each other respondent here has put in for me. I will carefully go over everything you've said. We're going to print this thread out and refer to, from time to time, like it's a book. I feel fortunate to have tripped over a forum filled with so many sharp (and helpful) minds.

I have thought about a financial advisor and I'm sure we'll need one at some point, even if not right now. We all learn somewhat by example and my mother had an accountant and an advisor, and changed advisors when she saw fit. I do want to manage my money a little bit more (well, a lot more) hands-on than she did, (in fact, she told me that my mantra from the time I could talk was "I'll do it myself!" so it'll be hard for me to let anyone tell me much of anything) not that she was in the dark by any means, and I have to remember that one reason she did it that way was that in the early 1970s when she began investing, there was no information superhighway, no Ameritrade or Etrade or Motley Fool or much in the way of resources for the average person. I guess the only way a non-financial professional could invest easily was to find an advisor with access to financial products. But I also noticed that she was not afraid of investing aggressively, and in fact was sometimes advised to scale things down, probably due to her age, and I'm also not afraid to be probably more aggressive (maybe I should be a little afraid. ;) )

I'll be going over the advice carefully. I'm sure we will have a house soon; just probably not for more than a year. Really, when the kids are small, you can give the oldest his own room and bunk two younger boys and a toddler girl in the same room, (they actually like having the little sister in their room, that's how sweet they are) but that arrangement won't make everyone happy much longer! :)

Link to comment
Share on other sites

Car loan math:

"The balance was originally $22,499, (now $20,452) the term is 72 months, and we're only 11 months into it, and the rate is (hold your stomach) 12.65%."

I think you said 200 rather than $2000 in principal payments that appear to have been made.

My trust HP 12C calculator says your payments should be $442.84 per month if 22.499 financed, 72 months at 12.65 percent. That's close to your monthly payment, but it should not be off more than a penny. So, I suspect you have something like "insurance" or other fudge factor in there.

Did you get this at a dealership? If yes, that may have contributed to your high loan cost. Dealer loan rates are generally not as competitive as a bank or credit union. I have trouble believing that you would get this rate if you shopped four loan sources.

I know this doesn't apply to you, but there are folks going to the "Bank of Mom" and offering 2% over her current CD rate (something like 6.5%) - both sides do better.

Maybe you are paying the price for a low credit score, but I haven't heard of an auto loan over 10% in years. If you had gotten a bad rate at 9.4%, you would have reduced your payment by about $50 per month.

If this was the best deal you could have arranged, leasing a car might have been better. But frankly, given the financial shape you portrayed, I would have opted for a five year old vehicle with about 80K miles. I bought a clean full size Pontiac from an FBI agent who was leaving the country for 5K (a very good price) last summer, and that car will be used by someone in our family for another 6+ years. You didn't say if this is a new car, or something special because of your one child... but I would not have committed to $5,400 a year - more than 12 percent of your income to any car. In that price range, some folks would just not buy collision, another way to cut down on expenses. I am not walking in your shoes, but from this vantage point, I would have opted for a less expensive vehicle.

Refinancing: First problem is does your car loan have a prepayment penalty? Second problem, it looks like even with a very low percent rate, you will have trouble getting you car payment below $400 per month.

Do you really save $9000 if you pay off the loan now? Not exactly. There is an "opportunity cost", the value of having the cash working for you. Let's say that instead of burning $20,452 to retire the loan that you instead put it in a conservative bond/stock fund and earn 6% each year. At the end of 6 years, you would have $29,011 to offset the interest paid out or about a gain of $8,559. I make not attempt to examine the tax liability/deductibility of this example, this is not a symetric set of solutions since the loan is fixed but the earnings of the investment are variable. I just do the math to say that what you could do with the cash offsets against the interest on the loan. Some scenarios could be more favorable to you then what I have used as an example.

Link to comment
Share on other sites

Guest ctfudge07

I mis-stated the original loan amount. It was somewhat over 23,000 and I plugged it into a calculator that spits out an amortization table on bankrate.com. The actual payments are 449.86 per month, and the balance is right now 20,452.46 (oddly, the payoff balance given to me on the phone today is about $300 more, and it's good for 15 days, and the additional has to do with interest - can't remember the exact information.)

I rounded a little by using a figure of 20,000 and plugging that into another calculator, showing me what I'd end up with in five years if it brought a return of 12%, and then by contrast I took the amount of the monthly payment (rounding to 450) and plugged that into another calculator showing me what I'd end up with in five years if those monthly contributions returned 12%. Of course these are all hypotheticals.

I even compared, recalculating for the "what if" of the scenario of refinancing at 5.9%, assuming no fees or anything, and I came up just about exactly even. NOT refinancing, I came out ahead to pay it off.

I'll go over it again and make sure I didn't make a mistake. You could use the same calculator I did (it's right in bankrate.com's auto financing section) but I did forget the exact original figure. I'll look it all over again.

Yes, it was from a dealer, and we were not in a position to do much comparison shopping for loans. (see short paragraph on credit, below.) I realize that it was an implusive decision to buy such a nice car, but I still don't regret it. We've had some real problem cars, not including the 8-yr-old Suzuki I've been driving for 7 years which is a no-trouble, reliable car. The one with the loan in question is a 2005, bought used in early 2006; it's a Chrysler Pacifica (seats 6) and cost considerably less than the new price of over $30,000. It seemed and still seems brand new. Our daughter only has a mild/moderate developmental delay and needs no special seating, but 6 people just don't fit (legally, with seatbelts) in a standard car and we dislike mini-vans.

I'm going to omit the details, but our credit was worse than you think, and people with poor credit cannot even get in the door at credit unions.

So yes, I get your point, but this is the nicest vehicle we've owned in... forever ;) and we plan to keep it forever (I've never traded in or sold a car, I don't think. I believe they've all basically been junked since prior to these two cars we have now, we've had end-stage cars, if you want to callthem that.) When I got the Suzuki (courtesy of my mom helping me out quite a bit by taking out the low-interest loan, making initial payments, and letting me co-sign, I finished paying the $192 payments in 2005 just before jumping into this newer car - we need two cars), it was the nicest car I'd ever owned too, also only one year old at the time (in 2000), but also $10,000 at the time, being a small Suzuki wagon. I can't say enough good about it, though, because aside from some brake maintenance and tires, it's needed nothing! (only seats 5 - uncomfortably - though.)

The car we had in between this expensive one and the lemon Ford was FREE, though. 15 years old, over 200K miles and leaking a quart of so of oil a day, my friend gave it to us just to get it off their insurance. We had it for less than a year before it went off to the demolition derby but hey, it got the husband to work and back every day for that year! The oil spot is still there for us to remember it by. And those kind of cars - the ones with no loan, either bought for a few hundred dollars or maybe even given away, they're such problems, are the main kind of car I've driven for a very long time. So we spent a little here and saved a lot there and there and there.

Link to comment
Share on other sites

Back to the IRA ---

I assume your 2006 income is extra high compared to 2005 and 2007 due to the inheritance. I also assume you like Roth IRA better than traditional IRA (I agree.). So here's how to get the best of both and save taxes. Contribute the max to traditional IRA for 2006 - you can still do it in 2007 up until you file your tax return (4/16/2007). At your income level, you can still get an IRA deduction (even though you contributed to a 401(k)) along with the Savers Credit to reduce your taxes for 2006. After you contribute for 2006, immediately convert to Roth IRA for tax year 2007. You'll owe taxes on the conversion and you should make an estimated tax payment to the IRS. Convert now and pay taxes while you have the extra cash, otherwise you'll never get back to it. Plus the sooner you convert, the less taxable earnings you'll have. When you convert, make sure you covert the entire balance to Roth IRA. Use other funds to pay the taxes. You effectively contributed to a Roth IRA, but you didn't waste the regular IRA deduction for the year you had high income.

Link to comment
Share on other sites

Guest ctfudge07

Thank you so much. Theoretically, our income should not be higher in any year since the proceeds of the estate come to us tax-free, but there was one part outside of the estate that we received in 2006 and that sum of $21,000 sure did drive our income up for that year only (I knew full well that it would.)

I follow what you are suggesting but I am unclear on this point: Will the tax on the conversion be less than the tax I would pay if I just opened a Roth IRA (and thus did not get the $8000 deduction from income in 2006)? I calculated that the tax savings I would get upon opening regular IRAs (one for each of us for a total of $8000 for each year) are $1,200.

Opening a traditional and converting it has crossed my mind but I assumed that Uncle Sam has crafty ways to keep people from pulling a fast one like you described. Let me mull this over, and in the meantime, let me know if the tax savings is substantial (I have not explored that.) Another drawback to that is that the five years (which may or may not matter but is used for purposes of withdrawals, like if we need to draw out of it for some reason like house downpayment) would not start untl 2007 this way.

I had pretty much decided on going with Roths only and eating the tax bite. I tend to believe in paying the taxes now rather than taking a little incentive and then having Uncle S. involved in every little thing I do with that money from here till eternity (with penalties at every step, too.) (Don't worry, I understand there are rules involved with Roths, also, and I've done a lot of calculating, too.)

I understand what you're saying about "wasting" the IRA deduction, but does it really matter when we're normally in the 15% bracket and have barely bumped up into the next bracket, even in 2006? (our total income for 2006 is 65,000). THANKS

Link to comment
Share on other sites

The quick conversion is NOT pulling a fast one on Uncle Sam. As a matter of fact you are allowed on unconvert up until October of the year following the tax year of conversion. Why? Suppose you converted a regular $20,000 IRA to a Roth IRA and paid taxes on that amount. Then shortly after, the investments tank to $15,000. Wouldn't you rather pay taxes on $15k than $20k.

But back to your original question on taxes. The taxes on conversion or Roth are really the same. A traditional IRA costs you both $8000 before tax since its a deductible amount in your situation. When you convert this to an Roth IRA, you pay taxes on the value of the account at conversion. Assume its still worth $8k - you owe taxes on ordinary income at your tax rate in the year of conversion. You should convert the full $8k and pay taxes from other funds. If you contribute $8k to Roth IRA, that money is after tax. So if its from current income, you paid taxes at your current tax rate. I was suggesting you contribute traditional for 2006 tax year to keep you from creeping into the 25% tax bracket.

Link to comment
Share on other sites

Creating and IRA then converting in a subsequent deal is a completely legal two step process as long as you meet the various qualifications. For example, you meet the income threshold and filing status in the year of conversion.

If you have the same marginal tax rate in year 1 and year 2, then there is essentially no advantage. In fact, if your investments moved up a lot in year 1, you would be taxed for more dollars being converted in year 2.

However, if your income in one year throws you into a higher tax bracket, the very crudely calculated advantage would be delta taxes (difference between the high and lower rate) applied to $8,000. Why "crude"... because it also depends upon state taxes (they can change, your residence might change), changes in federal tax rates, change in IRA assets over the year, etc.

I think you said that your boosted income barely throws you in the next bracket. Then you potential savings from the two step approach is the percent difference between the two brackets multiplied by the amount of dollars above the bracket step. If you only went 2,000 over the bracket and your tax rate delta was 13%, your savings would be around $260.

If you applied a 13% delta to the full $8,000, then your savings might reach $940.

Work your own numbers to determine if a two step is cost effective and worth the time/effort.

Link to comment
Share on other sites

Guest ctfudge07

I see now; thanks. It's a very good suggestion that would have benefited us a lot if our income had been huge for 2006, so I do appreciate the thought. Yes, we're only several thousand dollars into the next tax bracket, and I think the tax saved by completing this maneuver would be about $300. I think that, in combination with not getting access to the money for another year (if we needed it, and a five-year period starts when we start the IRA), it's probably not worth it.

I do appreciate the advice, though - I like to turn over every possibility.

Link to comment
Share on other sites

Woops missed that point.

One more aspect of a Roth is that you can always take out contributions without penalty and without tax impact. No five year wait on a contributory Roth.

But... that's not the point... taking out money prematurely erases the tax shelter value.

But this removal of Roth contributions at anytime feature does mean that your Roth can act in some way as a safety net - a no penalty source of funds in a pinch. A standard IRA carries a 10% early withdrawal penalty, plus everything is taxed as ordinary income.

Link to comment
Share on other sites

To ctfudge07 - I think you are putting too much emphasis on getting the 5 year clock started so you can access the money. In general for tax free distributions, the account must be 5 years old AND you must be age 59 1/2. Based on your age, there's no rush. Plus you can always get the contributions out with no penalty, and contributions always come out before ANY earnings do. You don't need to sacrifice $300 in tax savings just to make your money more accessable. It already is the most accessable retirement savings there is! (And therefore, you need good discipline not to touch it too soon.)

Link to comment
Share on other sites

Guest ctfudge07

You're right - I forgot that the five years applied only to earnings, and I considered it the most minor point, anyway.

I'll put more thought into this! Delaying taxes (if the amount does not increase, and in this case they'll actually decrease) is always a good thing!

Link to comment
Share on other sites

Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account in our community. It's easy!

Register a new account

Sign in

Already have an account? Sign in here.

Sign In Now
 Share

×
×
  • Create New...