Question

Individual retirement accounts (IRAs) were established by the U.S. government to encourage saving. An individual who deposits part of current earnings in an IRA does not have to pay income taxes on the earnings deposited, nor are any income taxes charged on the interest earned by the funds in the IRA. However, when the funds are withdrawn from the IRA, the full amount withdrawn is treated as income and is taxed at the individual’s current income tax rate.

In contrast, an individual depositing in a non-IRA account has to pay income taxes on the funds deposited and on interest earned in each year but does not have to pay taxes on withdrawals from the account. Another feature of IRAs that is different from a standard savings account is that funds deposited in an IRA cannot be withdrawn prior to retirement, except upon payment of a substantial penalty.

a. Sarah, who is five years from retirement, receives a $10,000 bonus at work. She is trying to decide whether to save this extra income in an IRA account or in a regular savings account. Both accounts earn 3 percent nominal interest, and Sarah is in the 30 percent tax bracket in every year (including her retirement year).

Compare the amounts that Sarah will have in five years under each of the two saving strategies, net of all taxes. Is the IRA a good deal for Sarah?

Instructions:  Enter your responses rounded to the nearest dollar.

If Sarah invests in the IRA, her net value (after taxes) five years from now will be: $  .

If Sarah invests in the normal savings account, her net value (after taxes) five years from now will be: $  .

Answer 1

The net value (after taxes) at the end of 5 years under IRA deposit option will be $8,115.

The net value (after taxes) at the end of 5 years under non-IRA deposit option will be $7,767.

Hence, IRA deposit is definately a good deal for Sarah as net proceeds will be higher by $348 under this option. The detailed calucations are presented in the tables below:

Non-IRA Deposit
Year	Opening Balance	Interest	Tax	Year End Balance
A	B	C	D	B+C-D
Year 0	10,000	0	3,000	7,000
Year 1	7,000	210	63	7,147
Year 2	7,147	214	64	7,297
Year 3	7,297	219	66	7,450
Year 4	7,450	224	67	7,607
Year 5	7,607	228	68	7,767
IRA Deposit
Year	Opening Balance	Interest	Tax	Year End Balance
A	B	C	D	B+C-D
Year 0	10,000	0	0	10,000
Year 1	10,000	300	0	10,300
Year 2	10,300	309	0	10,609
Year 3	10,609	318	0	10,927
Year 4	10,927	328	0	11,255
Year 5	11,255	338	3,478	8,115