Managerial Economics & Business Strategy 8th Edition by Michael Baye,Jeff Prince

Exercise 9

Suppose one of your clients is four years away from retirement and has only $2,500 in pretax income to devote to either a Roth or traditional IRA. The traditional IRA permits investors to contribute the full $2,500 since contributions to these accounts are tax - deductible, but they must pay taxes on all future distributions. In contrast, contributions to a Roth IRA are not tax-deductible. For example, if a person's tax rate is 25 percent, an investor is able to contribute only $1,875 after taxes; however, the earnings of a Roth IRA grow tax-free. Your company has decided to waive the one-time set-up fee of $50 to open a Roth IRA; however, investors opening a traditional IRA must pay the $50 setup fee. Assuming that your client anticipates that her tax rate will remain at 19 percent in retirement and will earn a stable 7 percent return on her investments, will she prefer a traditional or Roth IRA?