|
Rarely is new tax legislation cause for celebration, but in August 1997, Congress signed into law the Taxpayer Relief Act, which did retirement investors a good turn. It not only enhanced the traditional Individual Retirement Account, or IRA, but also introduced a brand-new investment option, the Roth IRA, designed to provide retirement savings opportunities to even more Americans.
Named for sponsoring Senator William V. Roth, Jr., Delaware, the Roth IRA
offers higher income limits and more relaxed eligibility rules than available with the deductible traditional account. Individuals earning up to $95,000 and couples earning up to $150,000 can fully contribute to a Roth--even if they're already covered by an employer-sponsored retirement plan. (To see if you should open a Roth or convert your existing IRA, check out the Roth IRA Planner.
But the real reason the Roth has grabbed the headlines is that it turns the traditional IRA formula on its head: Although retirement contributions are taxed up front, withdrawals can be made completely tax-free once you reach age 59 1/2.
While many investors have focused on the Roth IRA's lack of deductibility, for some people, paying taxes now to enjoy tax-free income later may actually make more financial sense in the long term. For one thing, the Roth IRA allows investors to effectively shelter more money for retirement. Although the annual contribution limit is the same for both accounts, because your Roth contribution is made with after-tax income, the full $2,000 can compound substantially over the years--without incurring any future tax liability.
Whether the Roth IRA is a better option really depends on your expectation of your future tax rate. In the past, retirees routinely moved into a lower tax bracket. However, with more people maintaining high levels of income even in retirement, it may make more sense to pay taxes on your contribution today, while you're still employed.
"Remember, it's not a question of paying taxes on the money," says former IRS tax attorney Greg Kolojeski. You're going to have to pay at some point. It's really just a question of timing."
For Kolojeski, the biggest advantage of the Roth IRA is one that's often overlooked: the ability to delay distributions. With no mandatory withdrawal age, you can contribute to a Roth well past the usual cut-off age of 70 1/2, allowing you to sock away substantially more assets for both yourself and your heirs.
"The Roth allows you to take the money out on your own timetable, not the government's," Kolojeski says. "Just imagine having another 10 or 15 years of tax-free compounding--that can add up to a tremendous amount."
Although investors can certainly open both a traditional and a Roth IRA, most financial advisers suggest that you convert your existing account to take full advantage of the Roth's long-term benefits. But before converting, consider these factors:
- You can only convert if your adjusted gross income is under $100,000 for the year the conversion occurs.
- More importantly, you'll have to pay taxes--which can be substantial depending on how much you've amassed in your current IRA--on all deductible contributions and earnings. To avoid being hit with penalties, you must pay these taxes with non-IRA money. In fact, tax experts caution that if you don't have other cash handy to pay the tax, you're probably better off with a traditional IRA.
|
