Author Topic: In defense of the Traditional IRA  (Read 7347 times)

Offline Dess

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In defense of the Traditional IRA
« on: March 09, 2011, 09:54:29 AM »
Jack has spoken passionately about the issue of Traditional vs. Roth IRAs and expressed a strong preference for Roth IRAs.  I've done some number crunching and my take-away is that a Traditional IRA is not only a good investment, but for the vast majority, a better investment.  To wit:

Take an annual income of $50,000 with an annual IRA contribution of 5% ($2,500).  The marginal tax rate for income up to $34k is 15% and up to $82k is 25%.  The base tax on $50k is $4,681 and the marginal tax is $4,000 for a total estimated tax of $8681.
 
Roth - A $2500 annual contribution compounded (@3%) over 30 years is $128,575.  All this time you have been paying $625 annually in taxes on the $2,500 or $18,750 over 30 years.

Traditional IRA – That same $2,500 contribution combined with the deferred taxes ($625) means an annual contribution of $3,125.  Compounded (@3%) over 30 years is $159,202.

The difference is Traditional IRA + $30,627.  

So the central question is:  “what tax rate would one need to be in to negate the $30k gain in income realized from a Traditional IRA?”

Further, let’s assume a standard deduction for an individual is $9,350 ($3,650 personal exemption + $5,700 standard deduction).  At a 4% withdrawal rate you can have an IRA balance of $233,750 and remain in the zero tax bracket.  You can have a balance of almost $862,500 and still be in the 10% bracket.   Or $2,072,500 and still be in the 15% bracket.

Going back to our example, we know that $159,202 paid at the deferred tax rate of 10% = $15,920, @15% = $23,880, or @20% = $31,840.

So, it turns out that in order to offset the benefit of deferred tax contribution and compounding interest one would need to have accounts valued at over $2 million dollars.  

What am I missing that would cause me to choose a Roth?   I don't foresee having in excess of $2 million dollars.  I don't foresee the 10% or 15% tax brackets being adjusted so dramatically that it will make a difference.  Tax rates for the bottom bracket have only exceeded 19% in 1945 (23%), 1951 (20.4%), & 1953 (22%).

I'm no financial wiz and have no skin in the outcome of a Roth v. Trad IRA debate.  I simply did some calculating and got a different answer than I expected.  So unless I see Harry Truman walking through the door I wont be converting to a Roth.  ;)

Would love to hear thoughts on this.
   

(yup, first post)

Offline EverStudent

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Re: In defense of the Traditional IRA
« Reply #1 on: March 12, 2011, 06:02:13 AM »
Dess,
Great first post!  It really made me reconsider my choices.

I think you really highlight some of the situations where a traditional IRA wins out.  The traditional wins when the interest earned is less than the amount contributed, since you are taxed on the total (you are able to contribute more).  The Roth shines when your interest earned exceeds the contribution, since you don't get taxed on the interest.  Based on the numbers you showed, the traditional comes out ahead.  At a little over 4.1% for 30 years, your interest starts to become the larger factor, but even with historical stock-market returns over 10%, recent events shows that it cannot be counted on, so I think your conservative estimation of interest is probably a good one.

If we change the contribution rate, the principal advantage of the traditional can be negated - if you are able contribute $5000 a year to a Roth, then the final balance is equal in both cases, regardless of interest rate.  For someone making $50000, that seems possible, but situations will vary from person to person.

I don't have the skills to run the numbers, but another factor to consider is if you have any other retirement income (pension, 401k, consulting, etc.).  Those other sources might raise your tax rate at retirement.

Offline daved

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Re: In defense of the Traditional IRA
« Reply #2 on: March 12, 2011, 07:26:48 AM »
Maybe this is a somewhat tinfoil hat type argument in favor of the traditional IRA, but this is my thinking. At some point the government is going to see all these Roth accounts sitting there with interest that hasn't been taxed. They will then change the way things work so they can get a piece of that action. I'm sure there are all kinds of reasons why this will never happen, but personally I don't trust them not to do it.

Offline Oil Lady

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Re: In defense of the Traditional IRA
« Reply #3 on: March 12, 2011, 07:37:17 AM »
I must concur with daved:

Maybe this is a somewhat tinfoil hat type argument in favor of the traditional IRA, but this is my thinking. At some point the government is going to see all these Roth accounts sitting there with interest that hasn't been taxed. They will then change the way things work so they can get a piece of that action. I'm sure there are all kinds of reasons why this will never happen, but personally I don't trust them not to do it.

I might have called this thinking tin-foil-hat prior to 2008. But then when we all watched that year as the banks and the credit card companies enacted retro-active changes to the terms of their bank cards, that's when I knew our country was no longer the nation I thought it was.

I had a brief stint about 10 years ago where I worked in high finance (and I hated it). My training at the time told me that very high income people were more suited for a Roth, while medium income and lower income people were more suited for a Traditional.

But I am now very leary of tying up my money for decades at a time with all kinds of strings attached when the future of the dollar is so uncertain and the trustworthiness of banks and even the US government to "do the right thing" is almost non-existent. The original wisdom behind the IRA was: "When you retire you will be at a lower tax rate than now, so even if the dollar tanks you'll still come out ahead." But that wisdom only works for as long as the US government ALLOWS me to be at a lower tax rate when I retire. They might change the retirement tax rate rules between now and my retirement with no guarantee that they will grandfather me and anyone else in my peer group.  

Therefore, my feeling is that the more control you have of your money, the better.




« Last Edit: March 12, 2011, 07:43:35 AM by Oil Lady »

Offline ModernSurvival

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Re: In defense of the Traditional IRA
« Reply #4 on: March 12, 2011, 11:24:19 AM »
First you have NO IDEA what tax rates will be when you retire but the odds are they will be higher.

Second it just never works like the scenario above people don't go well I am either going to do 250 a month with a conventional or 200 with a ROTH, people are people and they contribute what they contribute.  I have never met anyone actually contributing more because of the conventional tax advantage.  So in the end you end up in the REAL WORLD the same amount goes in and it is either all tax free or all taxable.

This is one of those things that work in theory but never actually works out in practice.  You can play with numbers till the cows come home but in the end the person that would stack 4K in a ROTH every year is going to end up stacking 4K in a conventional, they are not going to end up putting in the 4K plus the additional tax deferred part.  So if the same amount goes in then in the end the same amount comes out.  With a ROTH I can take as much as I want, when I want and will never pay a penny of tax on it.

Oh and once again you have no idea what tax rates will be in 2012 let alone 2032 and anyone pretending that they do is foolish in my view.  You have no idea what will constitute a zero tax rate in 2032 or 2042 and neither do I.  What we do know is the nation is going broke, the government is greedy and they will suck every drop they can get before they let it fail.  So when I get a chance to remove money, any money permanently from the tax system I do so.

In short with a conventional IRA/401/403 you are playing a game with your money basically based on a roll of the dice.  


Offline chrisdfw

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Re: In defense of the Traditional IRA
« Reply #5 on: March 14, 2011, 07:59:07 PM »
When you account for everything properly the only difference is what your marginal tax rate is now versus retirement, period, end of story, nothing further. I can prove it to everyone mathematically if you have a while.

So the real question is... Do you know your current marginal tax rate? Do you know your future marginal tax rate?

The questions are not as simple as it sounds. If your contributions are large enough it can end up being inter-marginal. In a great deal of cases where people are contributing a large amount of their income, the true optimization point comes from contributing to both. If you are in the 25% bracket you might be better off contributing enough to a regular IRA to get your income exactly equal to where the tax rate would drop into the next bracket but no more, and contributing anything further to the Roth IRA.

Also remember that tax rates in retirement are frequently higher than people expect because regular IRA withdrawals (including required minimum distributions) can cause income to increase to the point where social security becomes taxable, resulting in distressingly high true marginal tax rates. So everyone should be mindful that the decision is a function of expected investment returns, future tax law changes, and inflation (because tax rates are indexed to inflation).

I would in most cases recommend a Roth IRA to anyone who has a marginal tax rate of 15% or less. Beyond that it gets more complicated, but the true optimization often would be to contribute some to both. In any event it isn't really simple even without having to guess what happens in future congresses.

My opinion is that because of the budget deficits we are running, tax rates are likely to up.

If you are truly contributing a lot, then the Roth effectively allows higher contributions. Of course that costs the tax that must be paid, but since you are contributing after tax you are contributing more. Contributing after tax you get the tax savings, but are effectively contributing less. Most people indeed do not contribute the extra tax savings, but more people do make early withdrawals from the Roth because there is no tax penalty.

So the decision is pretty easy. All you need is a crystal ball and an in depth knowledge of the tax code.
 

Offline ModernSurvival

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Re: In defense of the Traditional IRA
« Reply #6 on: March 15, 2011, 07:31:16 AM »
@chrisdfw,

Again I state we have NO IDEA what tax rates will be when you retire but the odds are they will be higher.  What we do know is that a ROTH is tax free forever and that we can withdraw contributions (not gains) with no penalty if necessary anytime we decide to (yes this is fact, I was wrong about it myself at one time).  With a conventional we honestly have NO IDEA, NONE, ZERO, ZILCH what taxes the money will be subject to at withdrawal.  So you can go nuts with math, you can NEVER and I mean NEVER change the facts above.  Additionally if an emergency strikes with a conventional we have to pay penalties on any and all money withdrawn early.  Yea yea I know we can borrow it as though that won't just create a bigger problem for most people as they will never be able to pay it back in the time period required.

Conventional IRAs/401s had their day, that day was when they were the only option.  Today to avoid paying taxes on today's income there are better options, to save for tomorrow ROTHs win because they eliminate variables beyond your control and in the end as I said you end up with more money in the REAL WORLD.

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Re: In defense of the Traditional IRA
« Reply #7 on: March 15, 2011, 07:44:45 AM »
Jack's right no real point in me explaining what he did, again.  traditional IRA and 401K only make money when someone else contributes also (your employer)  when they match you get money from day 1.  if you put in $2.00 and they match 25% = $2.50  you just made 25% so top out your employers contributions and not a red cent more.  put it in a Roth.

Offline Orion53

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Re: In defense of the Traditional IRA
« Reply #8 on: March 15, 2011, 09:59:14 AM »
Jack,

Always appreciate your perspective in the matter.  Here's a question for you.  What are the chances that the governement will eventually mess with Roth IRAs or 401Ks in the future?  I agree with your assessment that tax rates will probably be higher in the future, so traditionals have one source of risk.  What about the risk the government decides to go after Roth accounts in some fashion?

Thanks,

O53

Offline chrisdfw

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Re: In defense of the Traditional IRA
« Reply #9 on: March 15, 2011, 10:15:18 AM »
Always appreciate your perspective in the matter.  Here's a question for you.  What are the chances that the governement will eventually mess with Roth IRAs or 401Ks in the future?  I agree with your assessment that tax rates will probably be higher in the future, so traditionals have one source of risk.  What about the risk the government decides to go after Roth accounts in some fashion?

If you don't mind, I will give you my perspective. Tax rates are likely to increase and broaden in the future. We can't afford to have half the population paying no income taxes. Nobody has a crystal ball, but the deficits point to the answer.

The most likely way taxes may change that affects IRAs is that we may see a Value Added Tax in the future. Possibly on top of income taxes but in place of corporate income taxes. This is likely to affect both regular and ROTH iras and really should not affect which is best.

My point earlier is that the optimization function is very very complex, even for someone with a background in calculus and differential equations. The factors that determine marginal tax rate are beyond many people's ability to grasp. In many cases the decision is not an all or nothing decision, some people will be better off mathmatically contributing 27% to a conventional IRA and 73% to a Roth IRA. But does anyone really want to add another layer of complexity to their life? Over half the population is better off with a Roth, certainly anyone with below the average income needs to use a Roth.

Offline ModernSurvival

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Re: In defense of the Traditional IRA
« Reply #10 on: March 15, 2011, 10:20:16 AM »
Jack,

Always appreciate your perspective in the matter.  Here's a question for you.  What are the chances that the governement will eventually mess with Roth IRAs or 401Ks in the future?  I agree with your assessment that tax rates will probably be higher in the future, so traditionals have one source of risk.  What about the risk the government decides to go after Roth accounts in some fashion?

Thanks,

O53

Well I will tell you that they will go after the conventionals first, why?  The money in them was never taxed.  What I really think will happen is that IRA, 401s will be changed in the future and existing accounts grandfathered.  Changing the terms on existing PRIVATE pensions just isn't possible because people WILL go to Washington and they WILL pull the clowns into the streets and they WILL string them up if they try.

Right now there is an all out attack on what morons call a "tax subsidiary for the wealthy" which believe it or not is what they consider IRAs and 401s because poor people (BTW who pay NO INCOME TAX) can't afford to contribute to them.  The government is eying that money but they just can't do it.  What they can do is "never let a crisis go to waste" and by the time the next big crash comes this is what I see happening.  

The assclowns will create a new "guaranteed retirement program" they will call it bipartisan by the way.  It will let you save money "tax free" but the catch will be some portion (a large one) will be in US Treasuries.  See they don't need to tax it if you are loaning it to them for a crappy interest rate you won't collect on until you are nearly dead.  Additionally this will put your money in THEIR control.  There will be some room for funds in these accounts but only the ones your masters say are "safe".  Existing 401s and IRAs will eventually be squeezed out.

Financial liars (um I mean advisers) will be trained to push the new guaranteed plans.  Every time the market dips your assclowns (oh um representatives) will beat the drum about how those in the new government program will not be so hard hit and have their income at retirement guaranteed (um ain't that the promise of social security).  At some point these new pensions will some how be merged with and "save social security" oh no SS taxes won't go away, just a reduction in direct benefits now paid out of your own contributions to these new fancy wiz bang plans.

Every effort and incentive will be offered to sucker people into converting ROTHs and Conventional 401s, IRAs, etc. into the new programs.  In the end we will have more taxes (the programs will end up mandated at some point even if the employer is simply mandated to offer them and ENCOURAGE THEM), we will still have social security taxes, we will get less in return (per dollar stolen from us) and anyone with an existing 401 or IRA will be fortunate to have not been suckered into giving them up.

See in the end our government is less likely to take something and more likely to convince you to give it away.  But go after existing 401s directly would make the riots in Greece and France look like a day at Disney World.  In short our government lives by a motto of "Never steal what you can sucker the people into giving you willingly and if you play your cards right you can even get them to demand you take from them".

Offline ModernSurvival

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Re: In defense of the Traditional IRA
« Reply #11 on: March 15, 2011, 10:22:56 AM »
Oh what I left out, the new programs will first be offered to government employees exclusively.  Who can tell me why?  ;)

Offline Dess

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Re: In defense of the Traditional IRA
« Reply #12 on: March 15, 2011, 07:55:25 PM »
You can play with numbers till the cows come home but in the end the person that would stack 4K in a ROTH every year is going to end up stacking 4K in a conventional, they are not going to end up putting in the 4K plus the additional tax deferred part.  So if the same amount goes in then in the end the same amount comes out.  With a ROTH I can take as much as I want, when I want and will never pay a penny of tax on it.

A fair analysis of what I wrote should make clear I didnt play with numbers. I took a reasonable scenario using conservative assumptions and the result suggests that Roths are not a better investment in many cases.  The compounding interest of the deferred taxes combined with what will surely be a lower tax bracket (not rate, mind you) outperforms paying taxes now and tax free withdrawals later.  The numbers are what they are. 

And I'm less confident than you that a person who can put away x amount in a traditional IRA can always afford to put x amount into a Roth plus pay the taxes.  I would submit that they will put away x amount, less the taxes.  This difference is a reasonable assumption and is part of why trads outperformed Roths in my calculations.  Compounding interest is powerful.

Quote
Oh and once again you have no idea what tax rates will be in 2012 let alone 2032 and anyone pretending that they do is foolish in my view.  You have no idea what will constitute a zero tax rate in 2032 or 2042 and neither do I.  What we do know is the nation is going broke, the government is greedy and they will suck every drop they can get before they let it fail.  So when I get a chance to remove money, any money permanently from the tax system I do so.  

A fair and reasonable point, Tax rates are likely to rise.  In the numbers I ran the break even rate was 19%.  If you believe the marginal rates for your projected future tax bracket will be greater than 19% then a Roth was the clear winner. If you think it will be less? Then a traditional was better performing.

I agree people should consider future tax policy changes in making inestment decisions, but they should understand what the numbers say and why they say it. They can then decide for themselves on what they think will happen.   A sweeping Roth is good, traditional is bad statement isn't correct in many situations and does a disservice.

Offline NWBowhunter

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Re: In defense of the Traditional IRA
« Reply #13 on: March 15, 2011, 08:11:34 PM »
Oh what I left out, the new programs will first be offered to government employees exclusively.  Who can tell me why?  ;)
Their pension funds are already broke if they can sucker them in it kills two birds with one stone. plus they can use the arguement that private should have the same benefits. Less the increasing attack on the outrageous pensions they garnering now.

Offline ModernSurvival

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Re: In defense of the Traditional IRA
« Reply #14 on: March 15, 2011, 08:29:02 PM »
Their pension funds are already broke if they can sucker them in it kills two birds with one stone. plus they can use the argument that private should have the same benefits. Less the increasing attack on the outrageous pensions they garnering now.

Nope! But close when you said, "they can use the argument that private should have the same benefits", when they give this wonderful gift to Fed employees exclusively, the sheeple will demand that it be made available to everyone.  Class warfare at its finest and most will fall for it.

Offline NotAGrasshopper

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Re: In defense of the Traditional IRA
« Reply #15 on: March 15, 2011, 08:49:34 PM »
Personally I think the government will eventually tax distributions from Roth IRAs (i.e., treat them like any other taxable investment account where post-tax money goes in and growth is taxed on sale or distribution).

There's no reason they couldn't do it.

Offline ModernSurvival

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Re: In defense of the Traditional IRA
« Reply #16 on: March 15, 2011, 08:56:30 PM »
Personally I think the government will eventually tax distributions from Roth IRAs (i.e., treat them like any other taxable investment account where post-tax money goes in and growth is taxed on sale or distribution).

There's no reason they couldn't do it.

I guess you missed this, or don't believe it

Changing the terms on existing PRIVATE pensions just isn't possible because people WILL go to Washington and they WILL pull the clowns into the streets and they WILL string them up if they try.

If you don't believe it fine but I would get my ass far away DC if it ever happens if I were you.  This is one of those things we simply won't stand for.  I know I won't, I will actually be on my way to DC if they ever did this and I would not be carrying a sign or a bullhorn, if you get my point.  Like I have said there is a point where they go too far, that would be one of them.

Offline ModernSurvival

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Re: In defense of the Traditional IRA
« Reply #17 on: March 15, 2011, 08:57:47 PM »
I guess you missed this, or don't believe it

If you don't believe it fine but I would get my ass far away DC if it ever happens if I were you.  This is one of those things we simply won't stand for.  I know I won't, I will actually be on my way to DC if they ever did this and I would not be carrying a sign or a bullhorn, if you get my point.  Like I have said there is a point where they go too far, that would be one of them.

Offline chrisdfw

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Re: In defense of the Traditional IRA
« Reply #18 on: March 15, 2011, 09:39:02 PM »
And I'm less confident than you that a person who can put away x amount in a traditional IRA can always afford to put x amount into a Roth plus pay the taxes.  I would submit that they will put away x amount, less the taxes.  This difference is a reasonable assumption and is part of why trads outperformed Roths in my calculations.  Compounding interest is powerful.

Even if you put less away because of the taxes, it ALL comes down to whether the tax rate is higher now or in retirement.

If your tax rate now and in retirement is EXACTLY the same, you will be in EXACTLY the same financial position if you invested in a Roth IRA compared to taking the same amoung and investing that amount plus the tax savings in regular IRA.

NO DIFFERENCE, never, not if. Lets compare

the future  value of a contribution to a Roth IRA is equal to your contribution C, compounded for Y years, at R rate of return.     C * (1+R)^Y
the future after-tax value of a contribution to a regular IRA is the same, less the taxes (at tax rate T)
(1-T)*C*(1+R)^Y   so obviously less because of the taxes, however if you contribute the tax savings (which is the only fair way to compare) your contribution is increased because the tax savings allow you to affrod more, your contribution is C/(1-t) (let t be your current tax rate)

So the after tax value of the regular IRA allowing for a higher contribution of the tax savings becomes   (1-T)*C/(1-t)*(1+R)^Y   if you let future tax rate T = current tax rate t
then (1-T) and (1-t) cancel out yielding   ..... C * (1+R)^Y
Which is the result for the Roth!!!

Of course this is assuming T and t are exogenous, which they aren't, they depend on C, R, Y and many other variables, but in the case where your marginal tax rate now and the future are the same, you are indifferent between a Roth and regular IRA.

Most people are better off with a Roth, because the marginal tax rate for almost half of the population is zero or near zero. This is not likely to be the case in the future. Additionally, there are estate tax and RMD factors that make a Roth more appealing. There is a lot to recommend in a Roth, but the analysis is never really simple except in the most clear cut of cases.

Another option to all of this is to invest in tax efficient investments where you defer your taxes and then pay capital gains rates (which I believe will remain lower than ordinary income rates) which offers you the non-tax benefits of liquidity.

A great deal of all of this relates to how you plan to spend your retirement. What will your income needs be, and how much do you need to invest to get there, do you have a pension, what are your earnings like, will you carry debt? etc etc etc

Offline fred.greek

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Re: In defense of the Traditional IRA
« Reply #19 on: March 15, 2011, 10:48:48 PM »
Roth vs “Traditional”?  Isn’t the government offering some special tax deal to convert your traditional IRA to a ROTH?  WHY is such an offer being made?  Do you trust that the politicians are REALLY thinking about your best retirement option?

Offline chrisdfw

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Re: In defense of the Traditional IRA
« Reply #20 on: March 15, 2011, 11:14:01 PM »
Roth vs “Traditional”?  Isn’t the government offering some special tax deal to convert your traditional IRA to a ROTH?  WHY is such an offer being made?  Do you trust that the politicians are REALLY thinking about your best retirement option?

Budget gimmick to get more revenue now to get things to fit in the congressional budget pay-go rules. All conversions pay tax now, politicians don't care about the future past the next election.

I don't trust them, but I can follow the money.

Offline ModernSurvival

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Re: In defense of the Traditional IRA
« Reply #21 on: March 16, 2011, 07:29:36 AM »
Roth vs “Traditional”?  Isn’t the government offering some special tax deal to convert your traditional IRA to a ROTH?  WHY is such an offer being made?  Do you trust that the politicians are REALLY thinking about your best retirement option?

No I don't trust the government but I THINK I don't just react, why are they doing it?  Well first it isn't a special deal, it is a deal that subjects the existing 401 to taxation but not penalties.  So every conversion equals tax revenue.  The government wants the money now, not later.  This isn't because ROTHs are bad, it is because if you are 35 your current retirement will never be taxed in time for the typical 8 term gray haired congressmen to ever spend a dime of it.

The truth is your government would LOVE it if every American cashed in and had to pay now, well except for how it would totally crash the stock market down to about 2500 from its current run around 11,800. 

I will tell you what, you can listen to all the numbers crap if you want to, you can listen to financial advisers try to sound smart or you can pay now and pay nothing later.  Just when you are 60something and paying taxes on money you saved 25 years ago don't say I didn't explain it.