For most of the past two decades, every January has been a time of heavy hype for IRAs as banks, mutual funds and brokerages vie for Americans’ retirement money. Now the hype has escalated with the introduction of the new Roth IRA. It’s been called everything from a dangerous boondoggle to the greatest gift Congress ever gave individual investors. I think the truth lies somewhere in between. Used correctly, a Roth IRA can be a terrific tool for building a significant nest egg over a lifetime of investing. Used incorrectly, it can be an expensive mistake.
If you haven’t already been bombarded with marketing materials from Roth purveyors, you soon will be. You’ll be urged to convert your existing IRA to a Roth IRA. You’ll be encouraged to visit your tax planner or financial planner, your lawyer or your accountant, all of whom (correctly, I think) see the complexities of the Roth IRA as a source of new business for themselves. Because so much material is available on the Roth IRA, we won’t try to cover all the details here. But we’ll hit some highlights and give you the essential information you need. I’ll give you my recommendations and tell you where you can get more information.
Here are 20 things you should know about the new IRA laws:
1. The Roth IRA is a different breed of cat. To figure it out, you have to reverse your thinking about the timing of taxes. The biggest difference is when – not if – you pay taxes. The financial industry for the past 15 years has taught us the wonders of getting growth and income now and paying taxes on it later. That’s what happens in a traditional IRA. Now the industry, wanting to push Roth IRAs, is reversing itself and touting the wonders of paying taxes first and getting your growth and income later. Can each scenario be better than the other? It depends.
2. Money you earn from dividends, interest or capital gains inside a Roth IRA is truly tax-free income. Inside a traditional IRA, that income is merely tax-deferred. That’s an important distinction.
3. The Roth IRA is full of potential traps for unwary savers and investors. See "Six things nobody knows about the Roth IRA" below for details.
4. The laws governing IRAs are now so complex that most people won’t be able to figure them out without professional help.
5. Your annual contribution to any combination of IRAs remains limited to $2,000.
6. A non-working spouse may now contribute up to $2,000 per year into an IRA regardless of the spouse’s income.
7. No tax deduction is allowed for any contributions to a Roth IRA, which is entirely funded with after-tax money.
8. In the Roth IRA, there is no maximum age for contributions, and no distributions are required until the taxpayer’s death.
9. There are two ways to start a Roth IRA. You can open a new account with up to $2,000. Or you can convert a traditional IRA into a Roth IRA.
10. Not everybody is eligible to start a Roth IRA. That eligibility starts to phase out for married couples filing jointly when their adjusted gross income (AGI) exceeds $150,000 – and for singles when their AGI is above $95,000.
11. Not everybody is eligible to convert a traditional IRA into a Roth IRA. You aren’t eligible if you are married and you’ll file a separate tax return from that of your spouse. And you’re not eligible if the adjusted gross income on your tax return will be $100,000 or more for the year you want to convert.
12. Converting a traditional IRA into a Roth IRA is a taxable event that can take a big bite out of your pocketbook and push you into a higher tax bracket. In effect, you will have to add the value of your converted IRA to your taxable income. That could disqualify you for part or all of deductions or other tax breaks you would otherwise have.
13. If you convert to a Roth IRA in 1998, you can spread the tax out over four years. But if you convert after this year, you’ll have to pay the whole conversion tax in one year. Either way, unless you are certain you’ll have the money to pay the taxes, conversion could leave you with a significant cash flow problem.
14. You can pay the conversion taxes by withdrawing money from your traditional IRA. But doing that will cost you dearly. Example: Suppose you make a partial conversion and owe $5,000 in taxes because of it. You decide to raise that $5,000 through a withdrawal from your IRA beyond what you convert. You’ll pay taxes on the $5,000 withdrawal (in effect paying taxes on top of taxes) plus a 10 percent penalty on the $5,000. If you’re in the 28 percent tax bracket, you’ll have to withdraw nearly $7,700 in order to get the $5,000 to pay taxes on the conversion itself. If you think that’s confusing, you’re right. It’s a reason tax and financial advisors could be in high demand.
15. There is no way you can know for sure in advance whether you’re better off with a traditional deductible IRA or a Roth IRA. The answer always depends on things you cannot know in advance, including your total household income this year, how long before you start making withdrawals, your future investment return and your tax rate when you make withdrawals.
16. IRA math is not simple. A $2,000 contribution to a traditional deductible IRA costs you $2,000. But a $2,000 contribution to a Roth IRA costs you $2,000 plus whatever tax you must pay on $2,000 of income. You can’t make a valid comparison of the future value of those accounts without making tricky (and probably inaccurate) assumptions. For instance, if you’re in the 28 percent tax bracket, your real out-of-pocket cost for the $2,000 Roth IRA contribution is $2,778. To make a valid side-by-side comparison, you have to assume that with a deductible IRA, you would invest the extra $778 in a taxable account, something that few people are likely to do.
17. You’ll have more flexibility with a Roth IRA than with a traditional IRA. You can accumulate wealth and leave it all to your heirs when you die. The law is still unclear, but if you can leave a Roth IRA to a young heir, it may be possible to "stretch out" the withdrawals over the life expectancy of your heir. Imagine that you left a Roth IRA worth $100,000 to a six-year-old granddaughter with a life expectancy of 75 years. Assuming a modest 10 percent growth in the account, your granddaughter could receive tax-free distributions totaling $12.3 million over her lifetime.
18. You can withdraw your original contributions to a Roth IRA any time without tax or penalty. However, the only way you can avoid the tax and penalty on the earnings is by waiting to withdraw those earnings until you are 59.5 years old and you’ve had the Roth IRA for at least five years.
19. Making a contribution to any IRA, Roth or traditional, deductible or non-deductible, is almost always preferable to making no contribution at all or to saving money in a taxable account.
20. There’s one other new type of IRA that has nothing to do with retirement. Called the Education IRA, it’s really an education savings account that lets parents and others save for a child’s education. Annual contributions are limited to $500 per child from all sources, including grandparents, and are not tax deductible. The $500 limit is in addition to contributions for other types of IRA. Withdrawals can be made any time until the child reaches the age of 30. Those withdrawals are free of all taxes if they are used to pay qualified educational expenses.
Six Things Nobody Knows About the Roth IRA
Thanks in part to Peter Newman, a CPA who is host of the popular Money Line radio program in Kansas City, here are some unanswered questions about the Roth IRA. Most of these will probably be clarified by Congress or the IRS later this year. But if any of these is important to your own situation, proceed with caution.
1. Will states that impose income taxes require you to include Roth IRA conversions and the earnings part of future withdrawals as taxable income? If so, this could significantly increase the cost of converting.
2. Will the appreciation portion of Roth IRA withdrawals be subject to the alternative minimum tax?
3. Will appreciation inside a Roth IRA be considered in determining the taxability of Social Security benefits?
4. How will Roth IRAs be treated after death when they are inherited? Will the IRS require distributions as it does with standard IRAs?
5. What penalty or other consequences will be imposed if a taxpayer converts a standard IRA to a Roth and later discovers he or she is ineligible because of the $100,000 income limitation?
6. How will the IRS treat the conversion of nondeductible IRAs? Can a traditional IRA that’s completely nondeductible be converted without any current tax? When a taxpayer has separate IRA accounts, one of which contains deductible contributions and the other nondeductible contributions, will the IRS allow selective conversions? For instance, will you be able to convert only the nondeductible IRA, much of which has already been taxed, in order to reduce the tax that results from the conversion? Or will every conversion be treated as distributions have been treated in the past, including both deductible and nondeductible funds in the proportion of all IRAs owned by the taxpayer?
Our Recommendations
Consider converting your traditional IRA to a Roth IRA if you can pass four basic tests. First, you’ll have to report less than $100,000 in adjusted gross income on your 1998 tax return. Second, you should believe your retirement tax bracket will be at least as high as your 1998 tax bracket. Third, you must have at least five years remaining until you want to withdraw the earnings part of your Roth IRA. Fourth, you should be sure you have enough non-IRA funds with which to pay the tax bill on the conversion.
Unless you are certain that you understand the ramifications, consult with your financial advisor or tax advisor before converting.
Even if you plan to convert in 1998, consider waiting until the second half of the year when tax laws and other implications are clearer.
If you convert to a Roth IRA, don’t buy any lottery tickets for the rest of the conversion year. Your winnings could push you over the $100,000 eligibility limit for conversion. (On the other hand, if you win a big enough jackpot, maybe you won’t care!) If you convert to a Roth IRA and subsequent events make you ineligible for such a conversion, you will not be allowed to restore the money to a traditional IRA. And you won’t be allowed to keep your money in the Roth IRA. As we understand the law, you will have inadvertently cashed out your IRA prematurely.
If you believe, as many people do, that the U.S. government will adopt a "flat tax" or other changes that will put you in a lower tax bracket when you retire, converting to a Roth IRA (and paying taxes at today’s rates) could be a bum idea.
If you have a retirement plan where you work, contribute the maximum that will be matched before you put money into any type of IRA. A 50 percent match from your employer is equivalent to an instant, guaranteed 50 percent investment gain.
If your choice is between a deductible traditional IRA and a Roth IRA, do the math both ways with your assumptions about returns, the time until you’ll withdraw the money and your future tax rates. The "resources" section on this page tells you how to get an inexpensive software program to make this analysis and how to do it free on the Internet.
If the choice is a non-deductible standard IRA or a Roth IRA, contribute to a Roth if you qualify.
If your income is too high to qualify for either a Roth or a deductible traditional IRA, contribute $2,000 to a nondeductible IRA.
If you have a young child, grandchild, niece or nephew, consider an Education IRA. With today’s college costs, $500 isn’t much. But it’s likely to be affordable for many parents, and the tax-free growth is a benefit. Annual contributions of $500 starting at age 2 and earning 12 percent per year will grow to nearly $25,000 by age 18. That might pay for the first year at a public college in the year 2016.
Resources
You’ll find plenty of written material on the new IRA rules in your mailbox, newsstands and bookstores. Not all of it will be reliable, because the laws are complex and will continue to change. In the final analysis, your financial advisor or tax advisor should be your best source of definitive information.
On the Internet, there’s a wealth of information on the Roth IRA. Start with www.rothira.com, a site designed for professional advisors but full of articles, forms and tools to help you figure out the new tax law.
Also, check out the T. Rowe Price IRA Analyzer, a $9.95 software program that provides a lot of information and will lead you through most of the decisions you’ll have to make. To order, dial 1-800-332-6407.
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