Updated: 1/6/2010 9:56 PM ET|
Your tax-free guide to retirement
The choice between a Roth and a traditional IRA often comes down to which one gives savers the most income in their retirement years.
You remember your first real job? The one where you calculated all the hours you'd worked, times the minimum wage, only to look at that much-awaited first paycheck and have the brutal realities of income tax shatter your teenage dreams of wealth?
Unfortunately, many hard-working, long-earning adults suffer the same fate when it comes to retirement. Many forget that all those pennies painfully saved and carefully invested are subject to income tax come retirement -- with one exception.
Experts tout the wonders of the Roth individual retirement account, a unique savings vehicle that allows individuals to sock away up to $5,000 a year -- $6,000 if they are 50 or older -- and pull out their investments, and any earnings, tax-free starting at age 59 1/2.
"Roth IRAs offer newer and younger investors huge benefits," says Jonathan Citrin, the CEO of investment advising company Citrin Group in Southfield, Mich. "Sure, you're not going to get that immediate tax deduction, which is really attractive when money is tight. But you're going to (thank) yourself tenfold when you're 59 1/2 and can start pulling that money out tax-free."
Money types have been fans of maxing out this sort of retirement fund for a long time, but until Jan. 1, 2010, Roths were limited to individuals with modified adjusted gross incomes of less than $120,000 and to married couples earning less than $176,000. There was also an option to transfer money held in a traditional IRA to a Roth IRA, but this was limited to individuals making less than $100,000 a year.
Starting Jan. 1, the feds nixed both the income and filing-status restrictions on converting a traditional IRA to a Roth, opening up the option for rollovers and new Roths to millions of Americans.
Even so, it may be tough to convince yourself the Roth is the way to go. Especially in these tough times, it can be tempting to rely on a tax-deferred retirement plans such as a traditional IRA, 401k, Keogh or SEP-IRA, which allow you to deduct contributions from your taxes now. But that means that you pay taxes on your investment gains later. And in most cases, it means a lot more taxes later.
For example, a 30-year-old who contributes the current $5,000 maximum annually to a Roth IRA could retire at age 65 with about $930,000 in the bank, assuming an 8% return. That is $930,000 tax-free. By contrast, if those same savings were stowed in a taxable account and withdrawn all at once at age 65, the investor would have just $698,000 after paying taxes.
Although those figures might be evidence enough, Roth IRAs come with other goodies. Unlike a 401k, for example, which requires investors to start withdrawing their investments at age 70 1/2, Roths have no such withdrawal requirement. In fact, Roth IRAs can be passed down to heirs, who can then build for their own tax-free retirements. The one caveat with this scenario is that those heirs do have to use up the inherited Roth IRA funds over their lifetimes, says Agatha Johnson, a financial adviser with the South Dakota offices of Eide Bailly, an accountancy and business advisory firm.
"The Roth IRA is a great tool for legacy planning," Johnson says. "If inherited, that thing will be stretched out and grow over your lifetime, then distributed tax-free."
If the Roth IRA is such a sweet deal, why doesn't everyone automatically use it?
There are some good reasons to opt for other retirement tools, experts say. First, if you are an older worker who will need to withdraw from the account in a few short years, it makes more sense to take advantage of a tax-deferred account, says Stuart Ritter, a Baltimore financial planner with T. Rowe Price.
"The decision between a Roth and a traditional IRA is not about tax mechanics -- it's about what approach gives you the most spendable income in retirement to do all those cool, fun, sexy things like travel, cruises and hip replacements," Ritter says.
One exception to the Roth rule is someone who plans to retire within five years and is anticipating their tax rate will drop significantly when they stop working. An example is Ritter's own aunt, who makes a healthy salary in the sky-high-tax land of California but plans to retire to the low-tax haven of Rhode Island in a few years.
"In her case, it's better to get a tax break on contributions now" with a SEP-IRA or a traditional IRA or 401k, he says.
Citrin also advises maxing out employer 401k matches before exploring other retirement tools. And because Roth IRAs join other retirement vehicles in their fees and penalties for early withdrawal, he urges investors to make sure they do not need the cash before locking away funds.
"You need to look before you leap because once the money is in, it shouldn't come out," he says.
Before thinking about putting money away for retirement, investors need to have a positive cash flow, their debt under control and a minimum three-month emergency fund, he says.
If all this sounds like a step you'd like to take, you can open your own Roth IRA through a brokerage such as Vanguard or Fidelity, or through an independent adviser, then fill it with any stock, bond, mutual or index fund of your choosing.
Thanks to the rule changes, today many are considering rolling over -- or converting -- a traditional IRA to a Roth. It is important to note that any converted funds will be counted as one-time income and taxed accordingly, so make sure you have the means to pay up come April 15.
Pamela Peacock, an Atlanta film producer, added a Roth IRA to her stable of retirement tools. For her, the decision was one part pressure from her money-savvy father and one part planning for a low-stress retirement.
"I figure that, if anything, taxes are going to go up, and I'd rather pay taxes now while I'm in the heat of my career and making money," Peacock says. "If I'm paying taxes off the top now, I never have to think about that again."
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