1. Suppose a taxpayer, when 35 years old, made one tax deductible $2,000contribution of her after tax salary to deductible IRA. Her investment (taxable corporate bonds)earned a 12%annual return and she must liquidates the investment 10 years later when she retires> Her tax rate is 35%, but she must pay an additional 10% excise tax because she liquidates the IRA before she reaches the age 59.5
A. After taxes, how much cash does she have when she liquidates the IRA?
B. Was it a mistake for the taxpayer to have set up an IRA? What would she have earned had she invested her after tax salary in the taxable corporate bonds directly instead of through an IRA?
2. A taxpayer is about to receive a $1,000 bonus payment from his employer. He would like to put this bonus into a retirement account. He has come to you for advice as to whether he should put the $1,000 into a traditional deductible IRA or a Roth IRA account. You learn that he faces a current marginal tax rate of 28% and expects to face the same rate in 40 years, when he plans to withdraw the funds at age 70. He expects to earn a pretax rate of return of 10% in either retirement account by investing the funds in corporate bonds. Advise the taxpayer what he should do.
Planning Problem 2
Equation 3.6 analyzes the choice between a deductible IRA and a Roth IRA for new contributions when the taxpayer wishes to contribute the maximum allowed. The equation indicates that if the taxpayer expects his future tax to decline, the contribution choice depends on the relative magnitude of the taxpayer's current and future tax rate t0 and tn, the holding period n, and the pretax rate of return expected R to be earned on plan assets (note also that the equation assumes any excess funds under the deductible IRA are invested in an SPDA) Assume the taxpayer current tax rate t0 is .40. Complete the following spreadsheet, first assuming that R = 10%. Then repeat the spreadsheet for R=5% and R=15
Holding period n tn=40 tn=.35 tn=30 tn=.25
5 years
10 years
20 years
30 years
Interpret the result of your analysis. How does the rollover decision vary as a function of the pretax rate of return, holding period, and relative magnitudes of tax rates?