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My husband and I are in our early 30's and late 20's respectively and earn a combined $85,000 a year, an amount we expect to double in the next couple of years. We're not yet eligible to participate in our company's tax-deferred retirement savings plan, but we're considering opening IRAs. Our questions: should we open IRAs now or wait a couple of years and should we do traditional deductible IRAs or Roths?
-- Anonymous, Boston, Mass.
Wait? Why would you want to wait to fund IRAs? The sooner you begin putting money away, the sooner it has a chance to begin racking up gains, and the more money you're likely to have at retirement. Procrastinate, and maybe that money will be spent rather than saved. So open those IRAs now.
In fact, if you open the accounts and put in the money before April 15, the contribution can count as your 2004 IRA contribution (assuming you had earned income last year at least equal to the amount of your contribution).
Leaning toward a Roth
As to the issue of which type of IRA to do, well, either one -- a traditional deductible or a Roth -- is better than doing nothing. So you'll be taking a positive step in either case. But if I were in your position, I'd be more likely to go with the Roth.
Here's why. The "we're not yet eligible" phrase in your question leads me to believe that at some point both of you expect to become eligible for your employer's retirement savings plan, whether it's a 401(k), 403(b) or whatever. And when you do become eligible, I recommend you fund the plan to the maximum, or at the very least put in enough to take full advantage of any matching funds your employer may offer.
Assuming you follow my advice and contribute to your current employer's plan -- and continue to do so at future jobs -- you will be racking up two important tax benefits.
First, you'll be lowering your current tax bill because the money you contribute to your company's savings plan isn't taxed. Second, the gains on the money you contribute also compound without the drag of taxes, which allows you to accumulate a larger nest egg than you would if taxes were being skimmed off those gains each year.
But remember: you're only postponing taxes, not avoiding them altogether. When you begin withdrawing money from your company savings plan at retirement (or, more likely, the IRA rollover account you'll move the money to after you retire), you will eventually have to pay taxes at ordinary-income rates both on your contributions and your gains.
In other words, for every dollar you pull out of this portion of your nest egg, you'll have to fork over a portion to Uncle Sam. So, for example, if you're in the 25 percent bracket and you withdraw $2,000 a month, you would have roughly $1,500 that you could actually spend.
A traditional deductible IRA works much the same way. You get a current tax break, your money grows tax-deferred and then you pay taxes at ordinary income rates when you begin making withdrawals in retirement.
The Roth, however, works differently. You invest after-tax dollars in the Roth. So you don't get the immediate tax break. But not only do the dollars you invest in the Roth grow free of taxes, the withdrawals themselves are not taxed.
Basically, a Roth is kind of a mirror image of a traditional deductible IRA and company savings plans like 401(k)s and 403(b)s. Instead of getting a tax break up front and paying the taxes in retirement, with a Roth you pay the tax at the beginning and get tax-free withdrawals after you retire.
Manage your future taxes
Which brings me back to the reason I recommend you now do the Roth. As I see it, you will have plenty of opportunities throughout your career to invest in 401(k)s, 403(b)s and other plans that allow you to accumulate a nest egg that you will owe taxes on in retirement.
From a tax-planning standpoint, however, it's also a good idea to have a pot of retirement funds that won't be subject to taxes. And that's where the Roth comes in. You pay the tax freight now so you don't have to worry about giving the IRS and state authorities their share in the future. Every dollar in the Roth is a dollar you can spend in retirement.
What's more, having money in the Roth means not every dollar of your retirement nest egg is vulnerable to future tax hikes by Congress, a body that's been known to raise tax rates now and then. In short, the Roth makes a great complement to company savings plans like 401(k)s and 403(b)s.
It gives you a chance to practice what I like to call "tax diversification" and gives you more flexibility during retirement for maximizing the after-tax value of your retirement nest egg. (For more on this concept of tax diversification, click here.)
Alas, Roth IRAs aren't available to everyone. If your income is above a certain threshold -- one that you and your husband may soon exceed if your income rises as much as you expect -- you may not be able to fund a Roth to the max, or maybe not even at all. (For details on income eligibility requirements, the contribution limits and lots of other nitty-gritty details about Roths, click here.)
So do the Roth now while you have the chance. You'll thank me 30 years from now when you're pulling tax-free income out of it in retirement.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "We're Not in Kansas Anymore: Strategies for Retiring Rich in a Totally Changed World."