SIMPLE IRA question

[Guest jchen78@gmail.com]

Hi,

The company that I work for offers a SIMPLE IRA plan and I participate in it. I don't need my contributions to be tax-deductible, and I like the benefits of a Roth IRA. My question is, would it be better for me in the long run if I just contribute to my SIMPLE IRA up to employee matching percentage, and then put the rest into a Roth IRA?? I don't know much about this at all. Thanks for your help!

[John G]

You don't say what the employee matching rules look like. Common ones are 50% match, generous ones are 100% match.

To put that in perspective - if you assume that you may make 10% annually with a stock mutual fund (a common assumptions, some do much better many worse) then it would take you about 7 years to double your money. With a 100% match, you double immediately. The corresponding time to equal a 50% match is about 3.5 years.

Unless the company forced you to buy their own stock and that seemed extremely risky (not a common practice anymore, but think Enron) then its a very high probability that the matching investment will outperform your other choices.

If you have extra funds after using up your match, you may want to: (1) over fund the plan - its simple, maybe you like the investments, (2) send extra to your IRA and possibly take a deduction, (3) push the money into a Roth, or (4) just invest in a taxable account. The last option may be attractive because you can leverage (an advanced investment technique), may have more sophisiticated investment choices (real estate, options, commodities...), and don't object to the long term capital gains treatment for taxes.

[Bird]

My question is, would it be better for me in the long run if I just contribute to my SIMPLE IRA up to employee matching percentage, and then put the rest into a Roth IRA?

I don't think we have enough information to say if it is "better" but I think your approach of making sure you get the full match is reasonable. FWIW, you say "put the rest into a Roth IRA," but the limits are different and mutually exclusive. For a SIMPLE, the max employee deferral is $10,500 (plus $2,500 catchup if over age 50). The IRA limit is $4,000 (plus $1,000 catchup if over age 50). So you can do what you want and "the rest" doesn't mean anything, unless you are talking about a self-imposed savings goal/budget.

(John G. maybe you missed that it is a SIMPLE IRA - 100% match on the first 3%, unless the special 1% cap is being exercised.)

[Guest jchen78@gmail.com]

I'm sorry for being unclear. When I say "put the rest" meaning the rest of what I can afford to put away in my retirement accounts. So for example, if I can afford to put away $3000 a year towards retirement, should I put 3% (what my employer matches) of my paycheck into the SIMPLE IRA and then the rest towards a Roth IRA? Or just put the whole $3000 into the SIMPLE? I still have a long ways to go til retirement, and from what I know I think a Roth would benefit me more, but I'm just trying to get a second opinion. Thanks for your help!

[jpod]

jchen: What do you mean when you say that you "don't need my contributions to be tax-deductible"? If you mean that your income is low enough that you don't pay any federal income taxes, then I like your idea about contributing only the amount necessary to get the maximum match. If you mean that you are in a very low income tax bracket, that's a tougher question.

[Guest jchen78@gmail.com]

jpod, I mean that I am in a low tax bracket. Can you explain to me why you say that would be a tougher question? To my understanding, I figure that it will be better to pay taxes now on my contributions than to pay taxes later on my distributions. But I am just unsure because I don't know how the growth on my account will be affected by using after-tax money as opposed to pre-tax money.

[jpod]

I say it is a tougher question because I am harking back to an issue discussed recently on this message board. The issue is whether down the road Congress will change or repeal the Roth rules such that the earnings on Roth contributions will be taxable when distributed. We've already had the debate over what Congress will or won't or might do, so I am not trying to resurrect it here. However, if you assume that Congress won't change the Roth rules, Roths are a great deal for someone in a very low tax bracket (or even in a high tax bracket in many cases). But if you think that Congress will tax Roth earnings, I would favor either maxing out on your SIMPLE contributions or investing directly in low-turnover mutual funds outside of a retirement account and get the benefit of long-term capital gains tax rates when you need to tap those assets for retirement.

[masteff]

But I am just unsure because I don't know how the growth on my account will be affected by using after-tax money as opposed to pre-tax money.

I see two issues, which you seem to be aware of as well. One is taxation. The other is growth of the investment.

Regarding taxation: being in a low tax bracket now and expecting to be in a higher tax bracket when you take distributions during your retirement years, then you'd likely be better off putting the additional money in the Roth. This is further supported by the fact that you are young and have many years for the money to compound. The taxes on the SIMPLE earnings would likely be greater than the taxes on the Roth contributions. Even if some catastrophe comes and Congress starts taxing earnings when distributed from Roths, you will still have gained by having the tax-deferred earnings.

Regarding growth: because both have compounding that is not currently taxed, if you picked identical investments, both options would have the same amount of growth. It's only when one investment is taxed year-to-year versus one that isn't, that you end up with differences in growth. For example, if you put the money in a savings account, where you paid tax on the interest every year, then you'd have less growth because the taxes would reduce the amount of future compounding. Since both the SIMPLE IRA and the Roth IRA are not subject to year-to-year taxes, then their growth potential is equal (assuming identical investment options).

A couple other things to think about. One is fees. Will the Roth IRA have annual fees until your balance is over a certain dollar amount? (If so, you can also look around, the investment company where your SIMPLE is may waive fees on other accounts you open with them.) Another is investment options. Does the SIMPLE IRA have investment options that are appropriate and competitive?

[Guest jchen78@gmail.com]

Ooh ok, I found the discussion about the possible amendment of the Roth IRA. That was an interesting thread. For now I'm just going to assume they won't do that to us.

Like I said, I'm not a very sophisticated investor. I'm 25 and have only been contributing to my retirement for about 2 years, but I only have a vague idea of what I'm doing. I chose one of those no-load target date retirement funds from T.Rowe Price. I try to read Kiplinger's every month, but it's just hard to know what to do when there are so many options out there. But I'm going to go ahead and open up that Roth and try to max it out, while continuing to contribute the 3% to my SIMPLE. And then when I can afford to contribute more, I'll put more into the SIMPLE. If anybody else has any more thoughts on this, please let me know. All of your comments have been a great help. Thanks!

[Bird]

I think you're on the right track. There's no known "right" answer but at least you're doing something and have a reasonable plan. Good luck.

[John G]

I think you have a lot of good info in this thread. You can't know in advance what is the perfect approach, just pick a scenario that makes sense and each year review what are your options and how you are doing.

You might want to search the "Target" funds on this board. I have tried to explain what they are and their limitations. Basically, they are aimed for someone like you who find the 8000+ fund choices confusing. What the fund is selling is their "concept" of how you should invest, replacing your thinking/choices. Do you really want their mix of bonds and stocks? I think many of these are too conservative. Are the overhead fees of this Target fund reasonable? Some are way too high. There is no miracle here, just very good fund marketing.

Keep reading Kiplinger. You will accumulate a vast amount of knowledge if you spend two hours a month spent reading financial mags . Right now you are way ahead of most 25 year olds.

As I tell my high school students (JA econ business advisor)... "You are in charge". You may not have gotten the IM from GW, but you are in charge.

Post again if you have questions about investment choices.