Author: A.T.

Doug Posten: “I get no tax deduction now on a regular IRA because my income exceeds the limit. If I cannot deduct the $2,000 now from my taxes, isn’t the Roth IRA better?”

Yes! Absolutely.

The Roth IRA is great for what might be called the lower upper middle class — people who earn too much to qualify for the traditional IRA deduction, but not so much as to be disqualified from contributing to a Roth IRA.

(I say lower upper middle class because in America, almost no one will admit to being upper class. “Upper middle class” is as high as we go — even if we earn half a million a year. So wouldn’t those who earn way above average — $90,000, say — be lower upper middle class?)

As reader Mike Carver put it: “For those of us who can’t make deductible contributions to the traditional IRA, the Roth IRA appears to be a no-brainer.”

Tomorrow: Still More on the Roth IRA

I told the “presumably fanciful” story of the guy who insured his rare cigars, smoked them, then tried to collect on his fire insurance. Robert Doucette was kind enough to point me to the mother of all myth-debunking sites, lest anyone think this might actually be true. I commend this site to you even if you don’t care about this particular story for its links to other amusing, but preposterous folklore.

In the same vein are several books by Jan Harold Brunvand:

• The Vanishing Hitchhiker: American Urban Legends and Their Meanings

• The Mexican Pet: More “New” Urban Legends and Some Old Favorites

• Curses! Broiled Again!

• The Baby Train & Other Lusty Urban Legends

• The Choking Doberman and Other “New” Urban Legends

This is a guy with a flair for titles. How can you not be at least a little curious? So I bought all five.

The baby train has to do with this notion that a certain married students dorm on campus had the highest birth rate on campus because of the train that came through every morning at 5 AM — too early to get up, too late to go back to sleep, so . . . and it all sounds sort of plausible except that Brunvand has apparently encountered this same legend as far off as Australia.

The Doberman was allegedly choking on three human fingers. So the vet, who had sent its mistress home rather than have her watch the required surgery, called her immediately with the warning that she leave the house immediately and call the police. Well, when the cops came they found a semi-fingerless intruder unconscious upstairs in the house. Thanks to the Doberman and the quick-thinking vet, tragedy was averted. And this episode, though no newspaper could ever track down the actual woman and vet involved, is reported in numerous different newspapers in numerous different cities throughout 1981, according to Brunvand.

You get the idea — he has scores and scores of such tales in his collection.

Next thing you know, he’ll be debunking Oliver Stone movies.

Tomorrow: Still More on the Roth IRA

Here’s the lowdown from one of your fellow readers I’ll call Witherspoon:

Financial Facts:

1. I am 43 and my wife 38. Two daughters 8 and 6 years old.

2. My salary — $40,000. Wife just started substitute teaching and coaching part time now that both girls are in school. Likely salary–$6,000. Dividend income from our stocks — $10,000.

3. Value of home: $165,000. Fixed 30-year mortgage at 8.25% on $85,000 with 27 years to go.

4. Credit card paid off monthly. No other debt.

5. Stock portfolio worth $620,000 (48 stocks and 3 mutual funds). The majority of this came from our parents reducing their estates though gifting and an inheritance from a grandmother. Stocks include $160,000 worth of Coca Cola with the rest a menagerie of phones, utilities, and growth stocks.

6. My parents are likely to fund the Virginia Prepaid Tuition Program for our kids college tuitions. They have purchased life insurance which equates to $150,000 in proceeds to us in the future. In addition, my parents net worth is in the $2.3 million range. I have 2 siblings.

7. My wife’s mother is worth slightly less than that and has one other child. She has set up a trust for our children that is worth $150,000.

8. I have been terrible about funding my 401(k) because of trying to live on one salary after we had kids and due to being downsized 3 times. Balance $1,700.

9. I have approx $200,000 life insurance on me and $80,000 on my wife. $1,000,000 umbrella policy also.

Questions:

1. I feel guilty about the 401(k). How important is it that I find a way to fund it?

2. We have an additional $20,000 coming in from the inheritance. Do we use it to pay off part of the mortgage, invest in the market for additional income which would allow us to fund the 401(k) or some other idea that I have not thought of?

3. Any other advice would be appreciated.

Well, free advice is worth what you pay for it, and I suspect some of your fellow readers may come up with far more perceptive suggestions than mine. That said:

1. Feeling guilty about your 401(k), while completely justified, (you should feel terrible!) does you no good at all. Instead, you should stop feeling guilty and fully fund it, since money will grow faster tax-deferred than taxable, and particularly if your employer, like most, kicks in 25 cents or 50 cents — sometimes even more — for every $1 you contribute. Can you imagine the lines outside a bank that offered depositors not a toaster but free money — a free $500 for each $1,000 you deposited? Can you imagine the riots? Everyone in town would be trying to get into that bank and yet you, who have a private door and no riotous crowds to brook, are, in effect, saying, “Nah. Not interested.” For shame, Witherspoon! For shame! [Note to readers with no sense of humor, no small number of whom seem to have joined us in the last couple of months: I’m kidding. Witherspoon knows I mean him no disrespect.]

2. It should be a snap for you to fund it. If nothing else, just sell a little stock each year if you have to. You may want to sell the stock on which you have the most modest capital gain, although if it weren’t for taxes, I’d suggest you’re awfully heavily weighted toward Coke. In fact, what the heck: given the new low capital gains rate, why not sell a little Coke? Given your modest income, made more modest by the mortgage-interest deduction and exemptions for two kids, etc., the tax rate on the gain will be minor.

3. It sounds as if you will also both qualify for Roth IRAs, and I would definitely put $4,000 a year into these as well, funding this, if need be, with sales of stock from your taxable portfolio.

4. Before paying down that $165,000 mortgage, look into refinancing it altogether, or all but this $20,000 of it, with an adjustable rate mortgage (ARM). Shop around — and be sure you fully understand the wrinkles of whatever you’re offered, since ARMs can sometimes be deceptive. But why should you pay someone to take the risk that interest rates will rise? That’s what you’re doing by paying for a 30-year fixed mortgage. Some people have to. They can’t afford the risk of rising rates. But you’ve got $620,000 in stocks to help you in an emergency. If your ARM had decent annual and lifetime caps, and you could be paying 7%, say, after figuring in all the costs, you’d be saving some nice money — something like $2,000 a year, thank you very much. Yes, the rate might rise — but it might fall, also. (From 1880 to 1965, home mortgages were almost never pegged above 6%.)

• Of course, if you know interest rates are headed back up, then this would be dumb — but if you know the direction of interest rates, it should be you, not me, dispensing the advice.

• (It would also be dumb to refinance if you think you might move any time soon, because of the closing costs you incur.)

• One place to start shopping around for a mortgage is www.quicken.com/mortgage. It includes a 15-minute “interview” that actually takes half an hour to run through, but is well worth it.

5. At your ages, more term life insurance should be very cheap, and ordinarily I’d suggest with two young kids you buy more. But with fairly wealthy, loving grandparents, you may not need any at all. I also worry that you’ve bought some kind of overpriced life insurance. Your wife has $80,000? That’s not a very round number. The kind of people who sell $80,000 worth are not necessarily the kind who offer the best values. With annual renewable term insurance, it’s easy to shop around (on the Internet, even), and you may find you could get a lot more coverage for the same money.

6. Forty-eight stocks and three mutual funds? On a total of $620,000? You’re even more ridiculously diversified than I am! Actually, it’s 47 stocks and 3 mutual funds on a total of $460,000 if you subtract the Coke. Talk about a lot of baskets! But I know how this can happen, and having happened, I wouldn’t rush to “clean things up” for the sake of appearance when taxes would be due on any sales.

7. I’m sure you’ve already done this, but be sure your girls have a computer. And given that the holiday season is upon us, don’t you think you should also get each of them a copy of My Vast Fortune?I’m not saying they’re not a little young for it, but c’mon — we just saved $2,000 a year!

Here’s the comment I ran last year:

You can easily have all you want by not wanting much. You can’t possibly have all you want by making more money.

And isn’t “want” the most intriguing word? It means lack (“For want of a nail the shoe is lost, for want of a shoe the horse is lost, for want of a horse the rider is lost” — George Herbert, 1651) and it means wish for — which are so often one and the same.

But we don’t want (wish for) the things we don’t know we want (lack) — hence the importance of advertising and the scary power of “Dallas” reruns in the Third World.

And “want” is only sometimes synonymous with “need.” Sure, for lack of a nail — but how about for lack of a Sea-Doo?

The miraculous thing about this country is that almost everybody has food, clothing, shelter, and extraordinary devices undreamed of until a moment ago in human history: radios, telephones, color televisions, cars, radios in their cars — even enough dough to fly across the country once a year, if they plan ahead and stay over a Saturday. I speak here not just of the great middle class. This list pertains to most (sadly not all) lower-income Americans as well.

I consider myself blessed that, in material terms, I don’t want (lack) anything, and don’t even really want much. (My friends will tell you this is just a lack of taste. They marvel at my satisfaction with mid-priced used cars and mail-order clothes.)

How might you become similarly blessed? Well, maybe you already are. Or maybe you will decide that not having to strive for stuff you don’t need is the greatest luxury of all.

Happy Thanksgiving.

* * *

That’s the comment I ran last year. One of you, Erik Sten, responded with such a charming message, I’ve saved it all this time to share with you. He writes:

I just forwarded your Thanksgiving comment to a friend who has been amazed that I’ve gotten along just fine without having a real job for about ten years. He and others have suggested that I do a book on living within one’s means. My response is that I know how to do it and anyone else can do the same but he or she must want, more accurately, desire, to do it. That I do not have a clue how to teach.

I’m a graduate of Yale Law School and spent many years in public service doing consumer protection work. I was effective enough to get myself fired from two positions because my bosses felt I was too aggressive for their political tastes. My philosophy was there is simply no justification for any degree of deception in the promotion of sales. It’s not fair to either the consumer or the honest competitor.

Shortly after I left my last professional position, I got my kids through college. I was divorced and realized I had nobody to please, satisfy or impress other than myself. I maintain myself through a few modest investments and the odd project, and I am satisfied or I’d be living differently.

I am blessed.

My younger son teaches in an alternative high school and is doing a marvelous job. He’s attended the funerals of several of his students who have died by guns. I couldn’t do it and am amazed anybody can do what he can. I couldn’t be prouder.

My other son was just elected to the Portland City Council. It’s only a five-person council so it’s quite an achievement for a 29-year-old. He won by better than a 3 to 2 margin after running a positive campaign that was noted for the large number of enthusiastic volunteer workers. He is a Generation Xer who will make an impact; you’ll be hearing more about him. I am fearful for the long-term impact of political pressures on his ideals, but I know that if we cannot encourage our best and brightest to be our leaders, then we’re in big trouble.

Hey, isn’t Thanksgiving great to cause us to think about these things?

The only holiday I like more is July 4, when I can read the Declaration of Independence on the back page of the New York Times. (Well, and maybe Christmas. Ho, ho, ho.)

Monday: One Family’s Finances (and How You, Too, Might Save $2,000 a Year)

A lot of you have written to ask what ever happened in the “Mr. B” lawsuit. The answer (sorry this won’t mean anything to those I’ve not yet browbeaten into reading my book — hang on, it gets better) is that he asked to settle for $1,200, we said no, and it drags on. But it looks as if Mr. B may have lost interest, now that he sees we’re resolute. It cost him nothing to try, thanks to Legal Aid; it cost us a few thousand dollars in time and legal fees to defend. You know the old gypsy curse: “May you be involved in a lawsuit in which you are in the right.” (Or something like that. Maybe it was Polonius who actually said it. In Danish.)

The point is: I’ve had it easy compared to this story, relayed to me — with admirable calm (I would be going nuts) — by Dan H., one of your fellow readers:

“I hope your landlord travails are going better. I am currently slogging through a difficult eviction. The tenants started out by suing me more than a year ago for breaking a leg on a carpet seam inside the house. When the medical records showed that they had originally claimed that the accident happened outside of the house, their attorney petitioned the court to be able to resign from the case. Yet the case lives on. Meanwhile, failing their first attempt to sue, they stopped paying rent, so I filed for eviction, which they are contesting on the grounds that it is retaliatory for the original suit (not that it could have anything to do with anything like, say, their failure to pay the rent!!). Alas, sometimes life can be rather frustrating.”

Separately, there’s an alleged news item going around cyberspace that I have to assume is a spoof. It concerns a Charlotte, North Carolina, man who “having purchased a case of rare, very expensive cigars, insured them against . . . get this . . . fire.” He smoked them all, then told the insurer he had lost them in “a series of small fires.” The insurance company balked; the man sued — and won. According to the story, rather than endure the time and expense of an appeal, the insurer paid the man $15,000. Then, after he cashed the check, it “had him arrested on 24 counts of arson, for which he was sentenced to 24 consecutive one-year terms.” While this amusing tale is presumably fanciful, tell me this: Is it that much more insane than Dan H.’s saga?

Ah, justice.

“Can I open an IRA for my 4-year-old and 7-year-old sons?” — Marie

Only if they earn the income you use to do it. Are they TV stars? Chimney sweeps? Even so, not all financial institutions will be willing to do this. But some will set up IRAs for minors — so far as I know, it’s completely legal.

“I’ve read a lot about converting existing IRA’s to Roth IRA’s but my question is whether I can convert PART of my IRA (100K of 320K). I’m 62 years old and don’t want to deal with the taxes on the whole amount.” — William F.

Yes, you can convert as little or as much of it as you want.

“Of all that I have read about the pros and cons of switching to a Roth IRA, no one has dealt fully with the transfer of non-deductible contributions previously made to a traditional IRA. Can these funds be moved to a Roth tax-free? If they can, isn’t it a no-brainer that they should be moved (since that would exempt any further taxes on their growth)?” — Paul Kroger

Excellent question. Several of you raised it. Yes, the nondeductible contributions to your traditional IRA are not taxed when withdrawn. So in that sense, if you qualify to move money from a traditional to a Roth IRA, (as you do if your 1998 adjusted gross income will be below $100,000) this would be a no-brainer. You’d be transferring money whose growth would be taxed at withdrawal to a Roth IRA where it can grow forever free of tax. Great!

But the appeal of moving to a Roth IRA will depend on the proportion of nondeductible contributions in your IRA versus deductible contributions and growth.

• If the bulk of your IRA’s value comes from nondeductible contributions — perhaps you just set it up two years ago, contributed $4,000 and now it’s worth $5,629 — then, yes, it’s a no-brainer. Switch to a Roth IRA if you qualify to do so and pay a little tax on the appreciation. (But note that in doing so — even if you’re over 59-1/2 — you begin the 5-year waiting period before which Roth IRA distributions are not tax-free.)

• But what if you had an IRA worth $89,000 of which only $4,000 represents nondeductible contributions (because, say, your income was too high in a couple of years to make a deductible contribution, but you chose to contribute anyway)? Now you’ve got a $4,000 tail wagging an $85,000 dog. In this extreme example, the fact that a tiny proportion of the IRA transfer to a Roth IRA would not be taxed would barely affect your decision at all. It might make sense to switch to a Roth IRA — or it might not. See my earlier comment — but the nondeductible contributions you made would have very little to do with it.

Clearly, the more any transfer to a Roth IRA would be tax-free, because it represented nondeductible contributions, the more reason there would be to make that transfer.

To see what T. Rowe Price has to say about all this, click here. For Vanguard’s analysis, click here. And for its cool on-line IRA analyzer, click here.

[Note: If you don’t transfer your entire IRA over to a Roth IRA, you have to account for the transfer pro-rata. Say you made five nondeductible $2,000 contributions to your traditional IRA, totaling $10,000 . . . but this $10,000, through adroit management and the marvels of a bull market, is now $22,000. If you transfer the full $22,000 to a Roth IRA, you’d pay tax on $12,000. Easy. But if for some reason you transferred only $10,000 of the $22,000, you couldn’t just say it was the nondeductible part, you’d have to work out the proportion of the blend — in this case, 45% was nondeductible contribution, 55% appreciation — and pay tax accordingly.]

Neither a borrower nor a lender be. Simple enough, no? I was so proud for finally realizing it wasn’t Ben Franklin who had said this, as I had long thought — it was Shakespeare.

And then Ed Vosik responded in this space: “It wasn’t Shakespeare. It was Polonius.”

“And here I had thought it was Ben Franklin,” I replied to Ed. “But wait a minute. Did you HEAR him say it? See a tape? How do you know? Anyway: Shakespeare said it, too. And gets extra points for saying it in English. (Non offensorum, amicus Polonius.)”

Now comes Jim Halperin:

“Actually, Shakespeare WROTE it, in Hamlet, in the form of a soliloquy of advice from Polonius to his son.”

And John:

“Polonius spoke Danish and probably would not have understood your apology written in Latin.”

Oy! I feel stupider with each passing day. (I was shocked, in the midst of the Diana tragedy, to learn that the members of the British royal family are German — and astonished to learn I was the only one in the world who didn’t know.) Danish? With a name like Polonius? I give up. Borrow and lend all you like. What do I know.

Soon: Your Feedback on Roth IRAs, Going Postal, Etc.

"I am a young individual starting to get my life on track. I want to start making some real money for the future, so I want to start investing. My knowledge of the stock market is very limited. How do you suggest I get started with a limited amount of money? I know a little about Mutual Funds, however I want to try investing on my own. Do you think this is wise?"

Well, it’s certainly wise to get your life on track and begin investing. Whether it’s wise to compete with experienced investors and professionals when your knowledge is "very limited" is another story. Even a Nobel laureate like Bill Sharpe, one of the great names in the investment world for his work identifying the importance of — and then quantifying — risk-adjusted return, invests much of his own money via index funds. These are funds with very low expenses and low taxable gains because they just buy and hold "the market" as a whole. You (and he) obviously won’t beat the market this way; you’ll trail it by about a quarter of one percent. But you’ll beat most other mutual funds, and most of your friends.

That said, investing on your own can be fun, exciting and profitable (or addictive, self-destructive and money-losing). Millions of us do it, and with the new ultra-low commissions available, the odds are much better than they used to be.

You might want to read books like A Random Walk Down Wall Street (Burton Malkiel) or The Only Investment Guide You’ll Ever Need (me) to get some sense of what you’re getting into. And you might also want to wait a few more weeks for Barron’s annual "Roundtable," which fills the first three or four issues of each new year. There, a dozen of the world’s top money managers describe what they like and hate and why. It’s fascinating reading and will give you more than enough ideas of what to invest in and avoid. You’ll also see how they think and what you’re up against in competing with them.

The good thing about the investment game, unlike many others, let alone Las Vegas, is that in theory everyone can win. Some will do much better than others, but over time everyone can participate in the growth and profitability of the world economy.

Good luck!

Yesterday, I reviewed the pros and cons of the new Roth IRA. You can set one up any time after the first of the year. Today: Who qualifies to contribute to a Roth IRA, and what about switching the money you already have in a traditional IRA into a Roth IRA?

First, the most you can put into a Roth IRA each year (or into a traditional IRA, for that matter) is $2,000 each for you and your spouse (including a nonworking spouse). What’s more, anything you do contribute to an IRA must be from earned income. So if you earn no money in 1998, even though you may have $1 million in dividends and interest, you can’t contribute to an IRA.

Who earns less than $2,000 a year? Well, kids, for one. And if a child or grandchild legitimately earns some money mowing lawns or designing web sites, then he or she should consider sticking that money into a Roth IRA. The case I made for this last year (and my scheme for getting the kid to go along with it) becomes even stronger with a Roth IRA. The money that accumulates over his or her lifetime will be entirely tax-free at withdrawal. A fantastic opportunity.

Unfortunately for high earners, the allowable Roth IRA contribution begins to phase out for single taxpayers with adjusted gross income over $95,000 and phases out completely at $110,000. For those who file jointly, the allowable contribution begins to phase out at $150,000 and is gone completely at $160,000.

Still that leaves most Americans eligible. (Those who are not can still make non-deductible contributions to traditional, taxable-at-withdrawal IRAs. But with the long-term capital gains rate as low as it is, the case for doing so is less compelling than it was.)

(Note that for the traditional, deductible IRA, there is no income test if you are not covered by an employer-sponsored retirement plan. But if you are, eligibility phases out fast: beginning with adjusted gross income of $30,000 for single taxpayers, $50,000 for those filing jointly.)

If you qualify to contribute to a Roth IRA, good for you. As discussed yesterday, you may want to set one up.

Now what about switching the money in your current IRA into a Roth IRA?

This can be done with no penalty, even if you’re not yet 59-1/2. But you can only do it if (a) your adjusted gross income is $100,000 or less, and (b) you pay tax on the money you transfer. If you’re switching $30,000 from a traditional IRA to a Roth IRA, and you’re in the 35% tax bracket (federal and local), that would be $10,500 in tax. For transfers made in 1998 only, the IRS will allow you to pay the tax over four years. (State income tax departments may or may not follow suit. I’m not sure whether that’s been worked out.)

This would make sense if you’re in a low tax bracket now (and would remain in a low bracket even with this added income from the transfer) but you expect to be in a high one when you retire. You’re young, living in a no-tax state now and are in the 15% federal tax bracket. You figure that by the time you retire, all states will have hefty income taxes and you’ll have accumulated enough other investment income to throw you into a high federal tax bracket.

On the other hand, if you’re in a fairly high tax bracket now — or would be if you withdrew $80,000 from your IRA this year! — it makes little sense to do so unless you expect your tax bracket to be high when you retire as well.

[Note: I assume, but do not know, that the states will follow Uncle Sam’s lead in exempting withdrawals from Roth IRAs from tax.]

If you have an IRA, you will be able to make your 1997 contribution as late as April 15 next year, just as you always could. My advice: do this as soon as you can. The earlier you fund any kind of IRA, the longer your money has to work for you.

For your 1998 contribution, and from then on, you will have a choice: Continue with your old IRA, as before, or set up a new one, called a Roth IRA, after William Roth, the senior senator from Delaware, who hatched it. In that case, the old one would continue to grow, but from then on you could split your maximum $2,000 contribution each year over the two of them any way you wanted.

If you have no IRA currently, this is a good time to consider whether you should start one — of either variety. (Or perhaps start yet another new kind of IRA, the education IRA, where the “R” stands not for retirement but for Education. But the limits and laws on that are independent of those for the two retirement IRAs, so let’s just ignore that for now.) Both are great, and there’s no telling for sure which will be better for most people, so don’t let indecision keep you from contributing to one of them. The examples that follow should give you a pretty good idea how to think about this.

The basic difference between the traditional IRA and the new Roth IRA is simple. With the traditional IRA, you get a tax break for your contribution today, but pay taxes on everything you withdraw. With the Roth IRA, you get no tax break now, but so long as it’s been in existence for at least 5 years, every penny you withdraw after age 59-1/2 (and even before 59-1/2 in limited circumstances, such as purchase of a first home) will be tax-free.

Advantages of the Roth IRA:

• Withdrawals are completely tax-free.

• Easier to qualify to contribute to it (see tomorrow’s comment: Who Qualifies).

• You can continue to contribute even after age 70-1/2, if you have earned income, and you need not begin withdrawing money until you’re good and ready — and then, according to any schedule you please. (With a traditional IRA, you must begin withdrawing by April 1 of the year after you reached 70-1/2, and minimums are prescribed by law.) For someone who’s going to live to 100 or beyond, and who may not need the cash right now — or may not even be retired at 70-1/2 (Ronald Reagan certainly wasn’t) — this is welcome flexibility.

Disadvantage of the Roth IRA:

• You don’t get a tax deduction (technically, an “adjustment,” which lowers your taxable income whether you itemize or not) for your contribution.

Basically, which IRA to contribute to in any given year depends on your assumptions about tax rates. If all income were always taxed the same, then a Roth IRA would always make more sense than a traditional one. To see why, let’s pretend all income were always taxed at 50% and all investments grew at 10% a year. Neither is true, but it makes the math easy.

You could put $2,000 into a traditional IRA and get $1,000 “back” in the sense that doing so would lower your tax bill by $1,000.

So now you have both the $2,000 in the IRA and the $1,000 you got back via the tax break, and both are growing at 10% a year . . . except wait! The $1,000 is growing in a regular, taxable account someplace, so it’s really only growing at 5% a year after tax.

After one year, the $2,000 has grown to $2,200 and the tax if you withdrew it would be $1,100. Right? Fifty percent of $2,200. The $1,000 “tax break” money, meanwhile, would have grown at 5% after tax to $1,050 — $50 short of what you need to pay the $1,100 tax. And year after year it gets worse. What you can earn on your “tax break” money, because it’s subject to tax, is always likely to fall short of the rate at which your IRA — and thus your tax bill when you withdraw it — is likely to grow.

Now, you might say: well, what if I could earn 15% on that $1,000 tax break money instead of 10%? And I’d say two things: First, 15% is still only 7.5% after tax in this silly example, so you’d still fall short. Second: if it’s so easy to earn 15% outside of an IRA, why wouldn’t you be earning it inside the IRA as well?

In other words, however fast or slow you can make your money grow, it will always grow faster tax-free than taxable. The “tax break” you get from the traditional IRA will either be frittered away (in which case you really come out behind), or else it will be invested subject to tax, which over the long run will almost surely amount to less than if it had been invested free of tax.

In the real world, though, tax rates are not all the same, and that’s where it gets tricky. Here are two general rules:

• The lower your tax bracket today, the more likely a Roth IRA will be to your advantage.

• The younger you are, the more likely a Roth IRA will be to your advantage.

Say you’re 24, that you qualify to contribute $2,000 to an IRA, and that you can compound your IRA money over a lifetime at 9%. You don’t plan to withdraw the money until age 70. (In the real world, of course, there would be other $2,000s from other years, and you wouldn’t withdraw all the money at once. But let’s just follow this one $2,000 chunk.)

If you are in the 15% bracket today, because you’re a 24-year-old starting out, and you expect to be in more like the 35% bracket when you retire, then the case for the Roth IRA is overwhelming. By foregoing a tiny tax break today — $300 in the case of 15% on a $2,000 contribution — you would save $37,000 in taxes when you went to withdraw that $2,000 — now grown to $105,000 — at age 70. For $300 today to be worth so much — $37,000 — 46 years from now is for it to compound at 11%; i.e., if you had chosen the traditional IRA and gotten your $300 tax break, you’d have had to find a way to make that $300 grow at 11% a year after tax just to break even versus the Roth IRA. And trust me: It is very hard to grow money at 11% after tax. (If it is easy for you, then surely you could also have been growing the IRA at 11% also — in which case your $2,000 would have grown to $243,000 instead of $105,000, and the 35% tax would be $85,000 instead of $37,000, and your pathetic little $300 would have had to grow at 13% after tax, not 11%, to keep pace.)

So if you’re in a low tax bracket now with the prospect of a higher one when you retire, it’s a no-brainer.

But what if you are in the 35% bracket now, between federal and local income taxes, and expect to be in the 15% bracket in retirement? In that case, taking the deduction now would save $700 on your taxes today (35% of the $2,000 contribution). When you withdraw that $2,000 at age 70, it will again have grown to $105,000 using the 9% assumption. Paying 15% of that in tax will cost you $16,000. So which is better: $700 now or $16,000 in 46 years? Well, that $700 would have to grow at 7%, after tax, for it to produce $16,000 after 46 years. So you have to think what you’d do with that $700 today. If you’d spend it on a new suit, forget it! You don’t need a new suit. Or, if you do, you can get a perfectly good one for a heck of a lot less than $700. In any event, a new suit is not going to produce $16,000 for you by the time you turn 70. But even if you were very disciplined and earmarked that $700 specifically to grow to pay taxes on your traditional IRA, the fact is, it’s not easy to beat 7% after taxes over a long period of time. So even in this scenario, the Roth IRA doesn’t look bad.

Now what if we kept everything the same as above but made you 64 instead of 24? You’re still in the 35% bracket, but expect to be in the 15% bracket when you withdraw the money at age 70 (because you’ll be retiring, moving to a no-income-tax state, and getting by on a very low taxable income). In this case, it would be smart to use the traditional IRA rather than a Roth IRA. Why? You save $700 on your 1998 taxes, and six years later, when you withdraw your $3,354 (it’s grown by 9% a year), your tax on it at 15% will only be $503. That $700, meanwhile, has grown to around $1,100 if its growth was subject to just 15% in taxes (or even less if it was all capital gain and thus entirely shielded from tax, and subject to a very light tax when the gain was realized). So why give up what could be $1,100 to save $503 in taxes? You’ve shifted income that would otherwise have been taxed at 35% into income taxed at 15%.

Even if you were 44, given these same assumptions, the Roth IRA doesn’t look great. By age 70, the $2,000 has grown to $18,800 so the 15% tax you avoid is worth $2,800. The $700 you could have saved today with the tax break from the traditional IRA would have had to grow, after tax, at just 5.5% to match that same value. And if you could have found some nice growth stock that rose at 9% a year, you’d be sitting with $6,579, and very nearly that much even after you paid some tiny long-term capital gain tax on it when you sold it. Still: the Roth IRA does at least relieve you of the concern that tax rates will be a lot higher when you withdraw the money. And it also provides you the flexibility and easier accounting referred to above.

It’s easy to see that the Roth IRA will not always make sense. The lower you expect your tax bracket to be at retirement, the less enticing it is. Still, there sure is something nice about “paying” a few hundred bucks (by not getting the tax break) in order to know your $2,000 will grow completely tax-free for decades to come.

Nuances:

• Note the distinction between your marginal tax bracket and your average tax rate. If I pay zero tax on my first $10,000 of income, 15% on my next $10,000, and 35% on my third $10,000 — to take a simple hypothetical example — then my marginal tax bracket is 35%, because on the last dollars I earn, I’m paying 35% in tax. But all told, I’ve earned $30,000 on which my total tax was $5,000, so my average tax rate is 16.7% ($5,000 divided by $30,000). See the difference?

• In most financial decisions — should I buy $25,000 of taxable or tax-free bonds? what does this $1,000 gift to the Salvation Army really cost me after tax? — it’s the marginal tax bracket you should look at. What’s under consideration are relatively few dollars at the margin of your finances: a little more taxable interest income, perhaps; a little more in the way of itemized deductions. And indeed, when you look at the impact of the $2,000 IRA contributions many of us make each year, it’s the marginal tax rate that determines just how big a break we get.

• But when the dollars grow large . . . when it’s not just a small difference at the margin of your finances but a huge chunk of your income that’s at stake, as a $105,000 withdrawal from your retirement plan is likely to seem large 46 years from now . . . you should think more in terms of what you expect your average tax rate to be by then. Sure, some of that $105,000 will be taxed at the top bracket. But much of it may be taxed at a lower bracket or not taxed at all. So even if you expect today’s brackets to remain unchanged (for 46 years? hah!), your average tax rate on withdrawals from your IRA may be a lot lower.

• This distinction further moderates one’s enthusiasm for the Roth IRA. For people with relatively little taxable income at retirement, the savings from the Roth IRA may be quite modest.

• Leave your riskiest investments outside the IRA (of whichever variety). You do that for three reasons. First, some risky investments bomb. Outside an IRA — but not inside — you can take a tax write-off on the clinkers. Second, on the risks that do pay off, taxes can be light anyway because of the favorable long-term capital gains treatment. Third, you’ll have the flexibility to do your charitable giving with appreciated securities instead of cash.

• Ain’t Congress grand? This is the perfect tax break. It actually gets people to pay more tax now, decreasing the deficit, by getting them to forego the traditional $2,000 IRA adjustment . . . and shifts the cost decades into the future, when there will be that much less income available to be taxed . . . leading one to wonder whether tax brackets in the distant future, on the money that is available to be taxed, will be so low after all. This is an argument for choosing the Roth IRA. But . . .

• What if Congress one day abolishes the income tax altogether in favor of, say, a national sales tax? Well then, the traditional IRA might prove to have been the wiser choice after all. You got the tax deduction now and had no tax due on the withdrawals. Personally, I don’t see it happening. But there are going to be an awful lot of retiree voters in a few decades. Maybe they’ll get Congress to abolish the tax on all retirement income.

• What if, strapped for funds, Congress finds some back-door way to tax Roth IRA withdrawals — say, by adding that income into the mix in calculating some modified Alternative Minimum Tax? Well, then, again the Roth folks would have gotten the shaft. They’d have foregone today’s tax break, yet been hit up for taxes tomorrow anyway. I don’t think this is likely either.

For most people, especially today’s low-bracket taxpayers — as well as those likely to spend rather than invest their tax breaks — the Roth IRA is likely to be a good deal.

Tomorrow: Who Does Qualify — and Should You Switch?