Brenda has $5,500 of before-tax dollars available for a one-time investment. She is in the 25% bracket and expects to remain in this bracket indefinitely. She can invest directly in a taxable bond yielding 8% before taxes, or she can open an IRA and invest in the bond within the IRA. She knows that she will need the accumulated funds before she reaches age 59 ½. Thus, if she invests in an IRA, she will incur a 10% penalty on taxable amounts withdrawn from the IRA. Note: The two parts to this problem are best solved using a spreadsheet.
a. If she invests in an IRA that allows immediate deduction of contributed amounts (i.e., a traditional deductible IRA), how many years must she wait before the IRA is a better vehicle than direct investment in the bond outside the IRA?
b. How many years must she wait if she invests in a Roth IRA? Reminder: Withdrawals from a Roth IRA first come from contributions and are a nontaxable return of capital. However, if Brenda withdraws the entire accumulation before she attains age 59 ½, the accumulated earnings will be fully taxable and also subject to the 10% early withdrawal penalty. Hence, in this situation, the Roth IRA operates exactly like a traditional nondeductible IRA (the Deferred Model instead of the Exempt Model).