Question

One of the simplest tax avoidance strategies is to contribute to a Roth IRA, although this may not be right for everyone. Some individuals, particularly low-income households that may be eligible for tax credits because of young children in the home, may benefit more from contributions to a traditional IRA. Here, you want to help Susan identify the best retirement savings option for her situation.

Susan is 25, single, and makes $42,000 a year. Susan does not have access to an employer-sponsored retirement plan, but she really wants to start saving for retirement. She can contribute $5,800 of pretax money to a traditional IRA, or she can contribute $4,930 of after-tax money to a Roth IRA. The $870 difference represents the tax that Susan has to pay. Assume Susan continues to make this same annual contribution for 30 years and earns 8% on her investment.

Use the time value of money (TVM) formulas to calculate what the future value will be and how much she will have after taxes are paid in retirement by completing the following table. (Round answers to nearest whole number)

	Traditional IRA		Roth IRA
Money available to save		$5,800		$5,800
Tax on money available to save		$0		$870
Net annual contributions		$5,800		$4,930
Number of years contributions are made		30		30
Future value at 8%		$		$
Retirement tax rate		24%		0%, Qualified Roth IRA distributions are tax free.
Tax		$		$
After-tax wealth		$		$

Assuming that Susan continues to save aggressively for retirement and accumulates enough retirement wealth so that she will be in the 24% tax bracket in retirement, which option is better for Susan, a traditional IRA or Roth IRA?


The better option for Susan is

Answer 1

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