Friday, February 25, 2005

There is only one significant advantage to Roth IRAs...

(Part 3 of 5)

...and that is the ability to take the principal out early without penalty. If you want to cash out the entire thing, you are better off with a traditional or non-deferred account. However, if you only take part of the cash, the principal, a Roth is the best choice.

Consider Ted, Neal, and Ralph again. Imagine that they each make their $1000 contributions, so that T=1000, N=R=750. After a while, the amount in their accounts has doubled, and they decide they want $750 in their hands.

Ralph has $1500, removes $750, and still has $750 there. This is not a taxable event for him.

Ted has $2000. To have $750 in cash, he actually needs to withdraw ($750 / 65%), or $1154, leaving $846 in his account.

Neal has $1500. Half of whatever he withdraws will be capital-gains profit, taxed at 15%. To get $750 in hand, he has to cash out $375 in principal and $375 * 1.15 to cover the capital gains -- a total withdrawal of $806, leaving $694 in his account.

Assume that the remainder for each man doubles before they hit 59.5 years old. Ted will have a total balance of $1683, or a withdrawable balance of $1262. Ralph will have a balance of $1500, all withdrawable tax-free. Neal will have a balance of $1388, or a withdrawable balance of $1236.


  • Ted: $1262
  • Ralph: $1500
  • Neal: $1236

This assumes contribution, g = 2, withdrawal, and g = 2 again. If the two g-values are different, it can lead to wildly varying results.

In the situation where part of the money will be withdrawn early, a Roth IRA can be the best choice.


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