PFIN 5th Edition by Randall Billingsley,Lawrence Gitman,Michael Joehnk

Exercise 3

Deciding between traditional and Roth IRAs. Malcolm Richards is in his early 30s and is thinking about opening an IRA. He can't decide whether to open a traditional/deductible IRA or a Roth IRA, so he turns to you for help.
a. To support your explanation, you decide to run some comparative numbers on the two types of accounts; for starters, use a 25-year period to show Malcolm what contributions of $5,000 per year will amount to (after 25 years) if he can earn, say, 10 percent on his money. Will the type of account he opens have any impact on this amount? Explain.
b. Assuming that Malcolm is in the 15 percent tax bracket (and will remain there for the next 25 years), determine the annual and total (over 25 years) tax savings he'll enjoy from the $5,500-a-year contributions to his IRA. Contrast the (annual and total) tax savings he'd generate from a traditional IRA with those from a Roth IRa.c. Now, fast-forward 25 years. Given the size of Malcolm's account in 25 years (as computed in part a), assume that he takes it all out in one lump sum. If he's now in the 40 percent tax bracket, how much will he have, after taxes, with a traditional IRA as compared with a Roth IRA? How do the taxes computed here compare with those computed in part b? Comment on your findings.
d. Based on the numbers you have computed as well as any other factors, what kind of IRA would you recommend to Malcolm? Explain. Would knowing that maximum contributions are scheduled to increase to $7,000 per year make any difference in your analysis? Explain.