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cloudeleven

Should I Concentrate On My Roth Ira Or 457(b)?

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A 457(b) plan is available to me at work. This is a really good plan that includes Dodge & Cox Stock, Calamos Growth Fund, Julius Baer International fund, and other good funds. All loads are waived. The plan itself has an annualized administrative fee of 18.9 basis points (0.189%).

 

I also recently opened a Roth IRA. Right now, I have TAVFX, FAIRX, and DODFX in it, and I plan to buy CGMFX soon.

 

I know people rave about the Roth IRA being great, but the 457(b) is even better for people who retire before age 59 1/2. You can withdraw the money (contributions and earnings) at any age with NO penalty. This is great since I hope to retire in my early 50s. However, the withdrawals (contributions and earnings) are taxed.

 

With the Roth IRA, there is a 10% penalty if you withdraw earnings before age 59 1/2 (unless you annuitize), and the earnings (not contributions) are taxed if withdrawn before age 59 1/2.

 

I'm 25 years old. My employer does not fund my 457(b) at all. It is entirely funded by the employee (myself). My annual income is $31,000.

 

Since the 457(b) has more attractive early-retirement withdrawal features, should I focus on funding the 457(b) as much as I can, then funding the Roth IRA?

 

Thanks for your advice.

Edited by cloudeleven

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I have a habit of doing my own calculations and haven't been able to figure out what is so superior about a Roth vs tax deferred option, but perhaps someone can tell me what I'm missing:

1. If you're in a particular tax bracket (say 28%), it doesn't matter whether you take the tax out up front or at the end, you wind up with the same amount of money. There'll be more money at the end with a Roth, but you'll proportionally pay the difference in taxes. Try this with the future value (FV) function in Excel if you want to check it out.

2. What does matter (besides employer matches, loans, early withdrawal and other features) is the difference between the tax bracket you're in when you contribute and the one you'll be in when you retire. If you think you'll be in a lower tax bracket when you retire, then the deferred tax plan is better. In practice, people early in their careers may do better to use a Roth (presumably they're earning less and in a lower bracket). People closer to retirement have to evaluate how much retirement income they're likely to have and make a choice based on that. You should be looking at your marginal tax rate, not your average one, as this is what will apply to any plan contributions.

3. The real wild card is guessing whether tax rates will go up or down over the long term. Note that the capital gains and qualified dividend taxes are very low right now, but they don't enter into this calculation. They are more likely to go up significantly than the earned income rates in my opinion, but who knows. I also ran a scenario of not investing in a qualified plan at all to see what effect compounding would have based on the 15% tax rate. I actually used 24.3%, because California's 9.3% tax is the same for earned income or capital gains.

I'm not 100% confident of having set the model up right, but it did perform less well than the retirement plan options in my case. The reason is that the tax effectively reduces the compound interest rate as opposed to the amount of money. The results would be better for investments that didn't pay annual gains or dividends, but instead accrued a large capital gain that would be taken less frequently (real estate?). In any case, my bet is that the capital gains and qualified dividend taxes will go back to more historical levels in the future, so using a Roth or traditional plan is still a better bet than just investing the money.

Anyway, I'd be interested in any comments.

Edited by kogutr

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