Wednesday, May 27, 2009

Conventional IRA Wisdom

My residential dorm just hosted a seminar on personal finance for graduating seniors so that they can be independent and not dig themselves into personal financial difficulties with credit cards, retirement savings, etc.

There were three major lessons (and I'm paraphrasing, because I don't have the presentation yet)
1. Don't be afraid of finances, take control of your budget, taxes and financial decisions.
2. Pay off your credit card bill in full at the end of every month.
3. Contribute to an IRA every year.

The first two I agree with wholeheartedly. Individuals should understand their spending habits and their tax situation, or they'll end up in trouble. I haven't done as much with this as perhaps I should, and after graduation I will spend some time with this. The second one I agree with as well. Credit card debt carries the highest interest rates in existence, and any long-term loans should be obtained from other sources (the bank, most likely) at lower interest rates.

However, the last becomes an interesting case.

There are two major kinds of IRAs that were discussed. There is a traditional IRA, in which you put money in and defer paying taxes on the money until withdrawal (usually for buying a first home or after 59.5). With a Roth IRA, you put after-tax money in, and then don't have to pay tax on the growth.

While for the vast majority of people, it makes sense to contribute maximally to their IRA accounts, it may not be the actual optimal choice.

Let's start with a traditional IRA. You don't pay taxes on the money you put in it, and then pay when you withdraw. The interesting part, however, is that when you withdraw, you pay at the tax rate of your tax bracket at the time, not at that when you put your money in.

It is widely recognized that if you believe you will be in a much, much higher tax bracket at 59.5 than currently, you may not want to put money in an IRA.

However, there's another component. If you believe taxes will be much higher at retirement than you believe now, then an IRA may not be appropriate.

Look at America. The Bush administration unbalanced the Clinton budget and expanded the deficit to half a trillion dollars (and a trillion dollars in the final year). The Obama budgets will likely run 1.7 trillion annually or more, which will swell the debt from 50-60% of GDP, where it is now, to about 80 or 90% of GDP within somewhere from 3 years to a decade.

For a worker in his or her early 20s, who (under current rules, which could quite easily change) will not be able to withdraw until almost age 60, it is a near certainty that those types of deficits cannot continue. The government will need to curtail spending significantly, but it will also need to raise taxes. The rich currently pay the overwhelming majority of taxes in this country. That will go up somewhat. The middle class pay much less taxes than they should, given their income, so their taxes must go up, as much as the current administration is trying to claim they won't.

These tax rates must be somewhat significant. Thus, investing in an IRA may put money into a higher tax regime and may be suboptimal.

This applies less to Roth IRAs, which, as I understand it, have fewer withdrawal restrictions. With Roth IRAs, the tax bracket issue comes up (many people in retirement have low incomes and thus pay low taxes), but it's hard to imagine US income taxes going DOWN, so the point doesn't apply here.

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