From: schindler@csa1.lbl.gov (AARON SCHINDLER)
Newsgroups: misc.invest
Subject: Re: What good is a non-deductible IRA?
Date: 31 Dec 1992 00:43 PST
Organization: Lawrence Berkeley Laboratory - Berkeley, CA, USA
Distribution: usa
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In article <1992Dec31.010001.2364@cs.yale.edu>, blenko-tom@cs.yale.edu writes...

>I am a student on a stipend and therefore see a lower tax
>rate than if I were employed. Assuming that my tax rate
>will by higher when I retire, it makes sense for me to
>contribute to an IRA now and to take no deduction -- a good
>part of the benefit arises from the differential in the
>tax rate (between now and when I retire). I haven't worked
>out the figures, but I suspect this becomes advantageous
>even if I end up paying an early withdrawal penalty
>(sometime after my tax rate goes up).
> 
>I believe the same reasoning works for anyone who expects
>there tax rate to be higher when they retire.  
> 
>	Tom

I have a gut feeling that you are wrong, Tom.  Compounding is the eighth 
wonder of the world, after all.  Let's work some numbers on this one.
(Another "What if...")

What if you are 25 years old now (A grad student age, approx.) and are in
the 15% tax bracket.  What if you get 15% return on your investment...
(Average return of the stock market over the last few decades.  And we can
afford a little risk with a 30 year horizon.)  And, just to be nasty, what if
you are in an 80% tax bracket when you retire...  (And you thought your children
were going to pay off the national debt.  :)

PAY TAX NOW SCENARIO

You start with $1.  After paying 15% tax on it you put $0.85 into your IRA.
59.5-25 = 34.5 years later your $0.85 will compounded at 15% to $145.53.  
You can then withdraw it from your IRA and pay tax on it.  Your cost basis 
is $.85.  The tax you pay is ($145.53-.85)*.8 = 115.74.  Your net return 
is $145.53-$115.74 = $29.79.

PAY TAX AT RETIREMENT

Again you start with $1.  You put $1 into your IRA pretax.  34.5 years later
your $1 has compounded at 15% to $171.21.  You withdraw and pay tax.  Now
your cost basis is zero.  Tax = $171.21*.8 = $136.97.  Net return is
$171.21-$136.97 = $34.24.

CONCLUSION

As you can see, even assuming a large differential in current tax rates
versus retirement tax rates, you are still better off taking 35 years of 
compounding rather than a lower tax bracket.

OPTIONAL (advanced) SECTION...  

As you can see, the opportunity cost for paying tax now was $0.15 compounding
at 15% for 34.5 years.  If Tom were going to fully fund his IRA in either
case, his opportunity cost would be different.  Do you see why?  In that
case his opportunity cost would be $0.15 compounding at (15%-current tax rate)
for 34.5 years.  This would lead to less of a difference between paying tax
now or paying tax later, but I am confident Tom would still come out ahead
by paying the tax when he retires.

|=======================================================================|
| Aaron Schindler                                Schindler@csa.lbl.gov  |
|                                                                       |
| "How I made my fortune?  It was really quite simple.  I bought an     |
| apple for five cents, spent the evening polishing it, and sold it the |
| next day for 10 cents.  With this I bought two apples, spent the      |
| evening polishing them, and sold them for 20 cents.  And so it went   |
| until I had amassed $1.60.  It was then that my wife's father died    |
| and left us a million dollars.                     --anon             |
|=======================================================================|

p.s.  Tom suspects that whether you take an early withdrawal from your IRA
and have to pay a 10% penalty has some bearing on the decision whether to
pay the tax now or at retirement.  It doesn't.  The penalty is the same as
an additional 10% tax and the cost basis of this 10% tax is zero in both
cases.
Newsgroups: misc.invest