s the new Roth IRA (individual retirement account) a better investment choice than the traditional IRA you've come to know? Or are you better off with the old standard?
Those are questions many taxpayers will ponder this year. Here we'll offer a few pointers to help you decide if the Roth IRA is right for you. But first, a look at its characteristics.
As with the traditional IRA, you can contribute the lesser of $2,000 or 100% of your earned compensation a year into a Roth IRA. But unlike the old IRA, Roth IRA contributions are not tax-deductible. But also, unlike the old IRA, you'll pay no taxes on the money you eventually withdraw if you've held the Roth IRA at least five years and: 1) you are at least age 59½, or 2) you die and leave the money to beneficiaries, or 3) you become disabled, or 4) you use the funds for a first-time home purchase (lifetime withdrawals limited to $10,000).
Note: The $2,000 annual contribution limit covers all your IRA options. You could put $1,500 in a Roth and $500 in a traditional IRA, for example, or $2,000 in one or the other, but not in both.
|Are you eligible?|
Clearly, the Roth IRA opens up possibilities not available with the standard IRA. With the standard IRA, you couldn't withdraw funds before age 59½ without paying penalties. But, for instance, if you're young and looking to buy your first home five years from now, the Roth IRA offers an excellent way to save for at least part of a down payment, tax-free.
Still, not everyone qualifies for a Roth IRA. If you're single, your annual modified adjusted gross income (line 31 on your 1040) must be less than $95,000 for you to be eligible for the full $2,000 annual contribution. Contributions phase out as modified adjusted gross income climbs to $110,000, above which you can't make Roth IRA contributions. Similarly, for married couples filing jointly, the income limits span from $150,000 to $160,000. Married people filing separately can't contribute to a Roth IRA if they earn more than $10,000.
If you're eligible, should you jump at the chance to invest in a Roth IRA? The answer is a definite "yes" for one group: those whose income is too high to make a deductible contribution to a regular IRA, but low enough to contribute to a Roth IRA. "For those people, there's absolutely no downside to a Roth IRA," says Natalie Choate, a Boston estate planning lawyer and author of "Life and Death Planning for Retirement Benefits" (ISBN 0-9649440-0-6).
But say you're also eligible for a regular IRA. For the 1998 tax year, singles with a modified adjusted gross income less than $30,000 and married couples filing jointly with a modified adjusted gross income less than $50,000 can make the full $2,000 contribution. Deductions phase out at modified adjusted gross incomes of $40,000 for singles and $60,000 for married couples filing jointly. These limits apply to earners having retirement plans at work; individuals without such plans face no limits. Would a Roth IRA be a smarter move for these taxpayers?
That's tougher to answer. It depends on your individual situation. For instance, if you expect to be in a higher tax bracket at retirement than you are now, a Roth IRA might be a sound choice. Sure, you'll sacrifice the tax deduction today. But eventually you'll be able to withdraw that money, plus earnings, without having to pay a penny of tax on any of it--at a time when your higher income bracket would mean a heftier tax hit.
Suppose you're not sure what tax bracket you'll be in when you retire. In that case it gets trickier to weigh the benefits of tax deductions now against tax-free earnings later. Should you cover your bets and split your annual IRA contribution between the Roth IRA and the regular IRA? That's one option, Choate says.
"It's the 'surf and turf ' approach," she says. "The defect of that is if it turns out the steak is good and the lobster is tough, then you think, 'Why didn't I get all steak?' If you're happy with one, you're going to be unhappy with the other."
If you expect to be
in a higher tax bracket
at retirement than
you are now,
a Roth IRA might be
a sound choice.
Converting makes sense
for people who won't
need all their IRA
money after age 70½.
|Conversions = confusion|
The law that created the Roth IRA also allows you to convert all or part of regular IRA accounts you already own into Roth IRAs. To be eligible for a Roth IRA conversion, your modified adjusted gross income must be less than $100,000 (not counting the funds converted), for individual and joint filers.
You also have to pay taxes on the IRA funds you convert. To ease the pain, the new law allows you to spread that taxable income over four years, if you convert during 1998. Should you convert? Here the decision gets murkier still.
Conversion makes sense for people who won't need all their IRA money after age 70½. The Roth IRA doesn't require withdrawals at that age, as does the traditional IRA. So you could let the money sit, earning for you, as long as you wish, even until you die. "Say I'm 75 and I die, leaving the IRA to my daughter," points out Robert Keebler, a Green Bay, Wis. certified public accountant and author of "A CPA's Guide to Making the Most of the New IRAs" (ISBN 0-87051-195-5). "She can take the money out over her lifetime. That's the most powerful thing about this: the ability to stretch out an IRA after you die."
Converting has other estate planning benefits, as well. But for any conversion a key consideration, says Keebler, "is if you can use outside funds to pay taxes on the conversion" so you don't have to dip into your IRA dollars, thus diminishing your tax-free yields.
Keebler adds a caution for people on, or soon to be on, Social Security. "For many years a couple may not have paid any taxes on their Social Security benefits," he explains. "However, if they convert to the Roth IRA it's possible that the additional income from the conversion could increase their modified adjusted gross income to such a point that up to 85% of their Social Security benefits would be subject to tax."
In general, however, people who intend to be in a higher tax bracket when they withdraw funds should consider converting at least some of their regular IRA into a Roth. Better to pay the taxes on the conversion today when your tax bracket is lower, and get tax-free earnings later when you're in a higher bracket. Still, even that's a gamble, Choate points out. "We could see a change to a flat tax, and you'd be sorry," she says. "Or the stock market could crash and you'll have paid taxes on the full value, but it's now worth half that. Things could go seriously wrong."
"The question always is how much do you have to pay to get the benefit," Choate adds. "You're paying something, so you have to figure out if it's worthwhile."
For help in assessing your best IRA moves, talk to a financial consultant or professionals at your credit union. <!--this is a good place to link to your credit union's services--!> You also can obtain information about Roth IRAs on the Web.
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