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The Roth Individual Retirement Account
The Roth IRA, available since 1998, presents a
potentially attractive alternative to the regular IRA long favored by many Americans
as a cornerstone in their retirement planning efforts. That's because a Roth
IRA may allow you to avoid future taxation of your retirement funds by making
nondeductible contributions now.
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Rules of the Roth IRA
Following is a summary of the rules for Roth IRAs:
Unlike the traditional IRA, contributions to a Roth IRA are nondeductible regardless of your income level or participation in a company-sponsored retirement plan.
Your contributions are limited to $4,000 a year ($8,000 for couples) in 2006. The contribution limit begins to decline or "phase out" for single taxpayers with adjusted gross incomes (AGIs) of more than $95,000 and for married couples filing jointly with AGIs of more than $150,000. Individuals with AGIs in excess of $110,000 ($160,000 for married couples filing jointly) are not eligible for a Roth IRA. Married taxpayers filing separately are not allowed to contribute to a Roth IRA. An individual's total contributions to all IRAs, traditional and Roth, may not exceed the annual contribution limit ($4,000 in 2006).
Contribution limits will increase in the years ahead. The annual contribution limit for a Roth IRA is $4,000 in 2006. It will increase to $5,000 in 2008. Then, the annual contribution limit will be adjusted for inflation. Older Americans are also able to make so-called "catch-up" contributions to a Roth IRA. The allowable catch-up contribution is $1,000 per year but is not adjusted for inflation.
Your contributions to a Roth IRA may continue beyond age 70 1/2. You are not required to start taking distributions from a Roth IRA at age 70 1/2, as you are with a traditional IRA, and you can continue to contribute as long as you have earned income. When a Roth IRA owner dies, however, his or her heirs must adhere to the same minimum-distribution rules that apply to regular IRAs.
The taxable portion of a nonqualified distribution is subject to a 10% tax penalty. If you make withdrawals that do not meet the rules for a qualified distribution, you'll owe taxes on all or a portion of the withdrawal. You must also pay a 10% penalty tax on the taxable portion of the withdrawal.
Retirement plan "rollovers" are permitted, but only from Roth-style plans.
If you are changing jobs or retiring, you can roll over funds from an employer
retirement plan such as a 401(k) account directly to a Roth IRA, but only if it is a Roth-style plan. Beginning in 2008, however, direct rollovers from a non-Roth plan will be allowed. The rollover will be treated as a conversion, with income taxes due on all proceeds.
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The Traditional IRA vs. the Roth IRA
When deciding whether a regular IRA or a Roth IRA is best for you, you'll want to compare the after-tax dollars that would be available to you under each option. This will depend on many factors, including your tax bracket, how many years you have until retirement, and when you wish to begin making withdrawals. For many people, a Roth IRA will result in more after-tax income during retirement because qualified withdrawals from a Roth IRA are tax free, while withdrawals from a regular IRA will be taxed.
For those whose contributions to a regular IRA are tax deductible and who are in a higher tax bracket today than they will be in during retirement, a regular IRA may be the smart choice.
If you are not eligible to participate in a company-sponsored
retirement plan, you can make deductible contributions to a regular IRA regardless
of your income level, up to $4,000 in 2006. Deductible contributions may be
reduced or eliminated for individuals who participate in a company-sponsored
retirement plan, based on their incomes.
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Conversion of a Regular IRA to a Roth IRA
In creating the Roth IRA, Congress included provisions
for converting a regular IRA to a Roth IRA. You must have an AGI of $100,000 or less to qualify for a conversion to a Roth IRA (this limit is scheduled to be eliminated in 2010). Since the investment earnings
and capital gains in your regular IRA have not been taxed yet, the government
will take its share at the time of the conversion. If you have a nondeductible,
regular IRA, its earnings will be taxed but the amount of your contributions
will not. The withdrawal from your regular IRA will count as income but will not affect your eligibility for a Roth IRA (or the $100,000 income limit) or trigger the 10% penalty usually imposed on early withdrawals.
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Which Is Right for You?
If you have a regular IRA and are considering converting to a Roth IRA, here are a few factors to consider:
- A Roth IRA may be more attractive the further you are from retirement. Why? Because the longer your earnings can grow, the more income you may have that is never taxed. On the other hand, if you convert to a Roth IRA close to retirement, your investments may not have much time to compensate for the associated tax bill.
- If your regular IRA contributions are nondeductible, you may be better off with a Roth IRA. That's because the distributions of earnings from your regular, nondeductible IRA will eventually be taxed. The qualified distributions from a Roth IRA will not.
- Your current and future tax brackets will affect which IRA is best for you. For example, if you are currently in a high tax bracket and expect to be in a much lower tax bracket during retirement, a regular IRA could be the best option. Why? Because you may be able to claim a deduction on your contributions now and then pay taxes on future distributions at the lower rate later. Keep in mind that some experts say you could still come out ahead with a Roth IRA if you can fund it for at least 12 or 15 years before retirement.
As you can see, there is no easy answer to the question, "which IRA is best for me?" As with any major financial decision, careful consultation with a professional is a good idea before you make your choice. In addition to helping you with calculations and projections, a professional is also likely to know what, if any, changes or clarifications have been made to the complex new tax laws. Remember, your retirement could last 20 years or more. How you live tomorrow could depend on the choices you make today.
The information contained herein is general
in nature and is not meant as tax advice. Consult a tax professional as to how
this information applies to your situation.
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Summary
- Roth IRA contributions are nondeductible, but qualified withdrawals are tax free.
- Individual contributions to all IRAs are limited to $4,000 in 2006. Note that this amount will increase in the years ahead.
- You may continue contributions to a Roth IRA after age 70 1/2, and there are no mandatory withdrawals.
- You can make penalty-free withdrawals from a Roth IRA before age 59 1/2 for a first-time home purchase or if you die or become permanently disabled.
Checklist
- If your income last year was near the limit that affects your ability to contribute to a Roth IRA, try to estimate what this year's adjusted gross income is likely to be.
- Speak with a tax or financial professional about your IRA strategy.
- Shop around for a Roth IRA that meets your needs. Evaluate fees, investment options, and the tools and resources that will be available to you.
