Question

You have 6K of spare pre-tax income that you're looking to invest for the future. Today you are in a combined federal+state marginal tax bracket of 27%. You are anticipating that in 40 years your marginal tax bracket on your retirement income will be 22%, and marginal long term gains bracket will be 13%.

You decide to invest $5500 in a Traditional IRA, pay taxes on the remaining $500 and invest it in a taxable account. You expect to earn an average annual rate of return of 10.7%. For simplicity, assume it'll be composed entirely of capital appreciation, with no taxable interim cash flows.

How much will you have in 40 years after withdrawing from the IRA, and cashing in your taxable account?

Remember that upon withdrawal you'll pay regular income tax rate on the tIRA money, and long term capital gains on the gains in your taxable account.

Answer 1

To calculate how much you will have in 40 years after withdrawing from the Traditional IRA and cashing in your taxable account, you need to consider the following:

Calculate the growth of the $5,500 invested in the Traditional IRA at an average annual rate of return of 10.7% over 40 years.

Calculate the growth of the $500 invested in the taxable account at the same rate.

Determine the tax implications when you withdraw from the Traditional IRA and cash in your taxable account.

Let's break it down step by step:

Step 1: Calculate the growth of the Traditional IRA:

You invest $5,500 in a Traditional IRA, and it grows at an average annual rate of return of 10.7% over 40 years. You can use the compound interest formula:

Future Value (FV) = P(1 + r/n)^(nt)

Where:

P = Principal amount ($5,500)

r = Annual interest rate (10.7% or 0.107)

n = Number of times interest is compounded per year (assuming it's compounded annually, so n = 1)

t = Number of years (40)

FV = $5,500 * (1 + 0.107/1)^(1*40)

FV = $5,500 * (1.107)^40

FV ≈ $81,122.51

Step 2: Calculate the growth of the taxable account:

You invest $500 in a taxable account, and it also grows at an average annual rate of return of 10.7% over 40 years.

FV = $500 * (1 + 0.107/1)^(1*40)

FV = $500 * (1.107)^40

FV ≈ $7,369.49

Step 3: Determine the tax implications:

a) Traditional IRA: When you withdraw from the Traditional IRA, you'll pay income tax. Assuming your marginal tax rate during retirement is 22%, you'll pay 22% in taxes on the $81,122.51.

Tax on IRA Withdrawal = 0.22 * $81,122.51

Tax on IRA Withdrawal ≈ $17,846.15

b) Taxable Account: For the gains in your taxable account, you'll pay long-term capital gains tax at a rate of 13%. The gains are approximately $7,369.49.

Tax on Taxable Account Gains = 0.13 * $7,369.49

Tax on Taxable Account Gains ≈ $958.43

Now, subtract the taxes from each account:

IRA After Taxes = $81,122.51 - $17,846.15 ≈ $63,276.36

Taxable Account After Taxes = $7,369.49 - $958.43 ≈ $6,411.06

Finally, add the amounts from both accounts:

Total After Taxes = $63,276.36 (IRA After Taxes) + $6,411.06 (Taxable Account After Taxes) ≈ $69,687.42

So, after 40 years, you will have approximately $69,687.42 after withdrawing from the IRA and cashing in your taxable account, accounting for taxes.