The Density of Your IRA

by Joe on April 13, 2012

Density of a retirement account? Have I gone off the deep end? Maybe, but let me explain, then decide. I wrote about time not being a factor in whether the Roth or Traditional IRA was a better account, and showed with an example how the results were identical if we start with the same sum of money. You can read Does Time Matter When Choosing the Type of IRA if you missed it, but the key point is that the example starts with $5000 pre-tax.

Note – the illustration above is my whimsical take on this concept and should be taken in that vein. More important, it’s not to scale.

What if we use $6666 instead? Why $6666? Because this is what you need to clear $5000 to put in a Roth IRA if in the 25% tax bracket, and grow to $50,000 from my example from yesterday. But we can’t put in $6666 pretax into the IRA, we would put away $5000, and take the remaining $1666, pay tax, and invest the $1250 net. The $5,000 pretax grows to $50,000 and nets you $37,500, and the $1250 grows to $12,500, but cap gain tax is due on the growth. About $1688 is due, so you net $10,812, or a total $48,312. While the Roth nets you the full $50,000. Just over a 3% difference. This results from my observation that the Roth is a denser account. In effect, by paying the tax up front, more money gets saved. With the ability to save in a 401(k) as well, for many people the point is minor, as the $22,000 limit of the combined 401(k) and IRA is more than enough for an individual to put away, and most are best served doing this pretax. However, for those trying to sock away beyond these limits, they may choose to pack their money into the denser Roth.

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