# IRAs: Four Facts You Should Know

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3 What are their respective asset allocations? The conventional way to arrive at the answer would be as follows. John has \$1,000 in stocks and \$750 in bonds. His asset allocation is 57 percent stocks and 43 percent bonds. Mary s allocation would be \$1,000 in stocks and \$1,000 in bonds. Her allocation would be 50/50. However, it should be apparent from our previous example that Mary s allocation must actually be the same as John s allocation. Her allocation cannot be 50/50. It would be 57/43. Mary s Holdings \$1,000 in Taxable Account (Stocks) \$1,000 in Traditional IRA (Bonds) Mary s Share Government s Share Mary s Share Government s Share \$1,000 \$0 \$750 \$250 If Mary wanted to have an allocation of 50/50, her holdings should have been \$875 of stocks and \$125 of bonds in the taxable account and \$1,000 of bonds in the traditional IRA. The reason is that 25 percent of the \$1,000 of the IRA s bond holdings belongs to the government as taxes. It is important to note that the tax code impacts the asset allocation of taxable accounts as well as IRAs. For example, if John had a taxable account that owned an equity mutual fund with a cost basis of \$1,000 and a present value of \$11,000 (assuming a long-term federal and state capital gains tax of 20 percent and no step-up in basis expected), for the purposes of determining John s asset allocation we should consider that he holds not \$11,000 of equities but just \$9,000 because the government owns \$2,000 of the \$11,000 (20 percent x the \$10,000 unrealized gain). Fact Four: The Expected Difference in Tax Rate Should be a Factor If an individual has a choice between contributing to a traditional or Roth IRA, the preference should be based on whether the expected tax rate on withdrawal will be higher or lower than it was at the time of contribution. If the tax rate at withdrawal is expected to be lower than at contribution, the preferred choice should be the traditional IRA. The reason is that the government will own a lower percentage of the investment dollars. Let s look at an example. Let s assume John s tax rate is 25 percent on contribution. He can contribute \$1,000 pre-tax to a traditional IRA or \$750 after-tax to a Roth IRA, with his investment earning a return of 33 1/3 percent. How do his accounts fare if John s tax brackets are different at withdrawal than at the time of his contribution? John s Retirement Account Withdrawals After Taxes Tax Bracket 25 percent at contribution, 15 percent at withdrawal Tax Bracket 25 percent at contribution, 33 percent at withdrawal Traditional Roth Traditional Roth \$1,133 \$1,000 \$893 \$1,000 As shown in the table above, John should prefer deposits in a traditional IRA if he expects his tax bracket to be lower at withdrawal than at contribution. On the other hand, if the tax rate at withdrawal is expected to be higher than at contribution, the preferred choice should be the Roth. However, there is another consideration. Maximizing the Benefits of the Tax Code

6 a certain dollar amount. We prefer the latter approach for its simplicity. However, either way will help with making the right decisions. Hopefully, this has shown how essential it is to integrate the tax code into investment plans. Understanding the differences between the two accounts and putting those differences to the client s advantage is one way a good financial advisor can add value. 1 We urge caution in using software tools that purport to analyze the benefits of traditional IRA and Roth IRAs. They often contain errors, missing some of the key points raised in this document. This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Copyright 2007, Buckingham Family of Financial Services.

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