How to pick the best IRA CHOOSING the most appropriate of the three types of IRAs can help make your retirement cushy. Here's how you can do it right and invest your IRA cash wisely in 1998 as well.
(MONEY Magazine) – You know from reading the newspaper that starting on Jan. 1, there are three types of Individual Retirement Accounts (IRAs): traditional deductible IRAs, which are generally best for older or less affluent investors; new Roth IRAs, which are named after William Roth (R-Del.), chairman of the Senate Finance Committee, and are most appropriate for the young and affluent; and nondeductible IRAs, which are suitable for anyone not eligible for the other two options. Also, you may be able to convert old IRAs into Roths come New Year's Day. Salivating over potential commissions and fees on the $1.3 trillion that is currently invested in IRAs, the nation's banks, brokerages and mutual fund companies are now jockeying to help you figure out exactly which account is best for you. While these companies are generally hyping the Roth IRA as the best thing since the self-cleaning oven, you can get burned if you don't consider all your options carefully.
It's true that the Roth IRA, plus new rules that make it easier for millions of people to qualify for deductible IRAs, will save Americans a total of $20 billion in taxes over the next 10 years, according to the Congressional Joint Committee on Taxation. But how to get your share of that windfall is hardly straightforward. "A lot of professionals, never mind investors, haven't figured out the IRA changes," says Ben Norquist, a consultant at Universal Pensions, a financial services advisory firm in Brainerd, Minn.
To get an accurate picture of which IRA moves are wisest, you have to factor in your age and current tax rate as well as your anticipated retirement age and tax rate once you start taking the money out. Then--there's no getting around it--you have to do the math. For that, either consult a financial planner or use mutual fund company T. Rowe Price's IRA Analyzer ($9.95 on CD-ROM and diskette; 800-333-0740) or fund behemoth Vanguard's free online calculator (www.vanguard.com).
To make your task easier, we've interviewed three dozen of the nation's top tax lawyers, policymakers and financial planners. Armed with their advice, we'll first help you decide which kind of IRA to invest in (probably a Roth). Then we'll address whether you should convert your existing IRA or IRAs to a Roth (think twice). And in the box on page 76, we'll suggest the best investments for any IRAs you open in 1998.
SIZING UP THE THREE TYPES OF IRAS
Let's begin with a brief refresher course on the new IRA rules laid out by the 1997 tax law that distinguish the three places you can invest your $2,000 a year:
Traditional deductible IRAs. As you probably know, universally deductible IRAs, introduced by Congress in 1981, give you a tax benefit right away. You deduct contributions from your taxable income in the tax year that you make them. The earnings grow tax deferred until you withdraw the money, when you pay taxes on the balance. Perhaps you contributed to these IRAs in the '80s but stopped after 1986 when Congress limited the amount of income you could earn and still get the up-front write-off. If so, it may be time to take a fresh look.
That's because Congress just raised the adjusted gross income threshold for deducting an IRA, even if you have an employer-sponsored retirement plan. The new thresholds: $50,000 this year (rising to $80,000 in 2007) for married couples and $30,000 for singles ($50,000 in 2005). That's up from $40,000 and $25,000 respectively. What's more, if your spouse is covered by a pension plan at work but you're not, you can now deduct a full $2,000 contribution, so long as your combined AGI is under $150,000. Another important change: If neither of you has a retirement plan and one of you has earned income, you can each deduct up to $2,000. Consequently, this year, more than 90% of adults in the U.S. will qualify to contribute to deductible IRAs.
Roth IRAs. As of Jan. 1, 1998, each spouse of a married couple with a total AGI of as much as $150,000 ($95,000 for singles) can make a $2,000 annual contribution to a Roth, whether or not he or she has a retirement plan at work. While you'll have paid taxes on the money you put into a Roth, the IRS never gets a bite of the earnings you build up--even when you take out the money--as long as you are 59 1/2 or older or meet certain withdrawal requirements. (If you withdraw money before your account is five years old, the earnings are taxed and you may face a 10% penalty to boot.) "For the first time, your retirement assets can grow fully tax-free," says Barbara Raasch, a tax partner at the accounting firm Ernst & Young in New York City.
Nondeductible IRAs. This third type of IRA gives you tax-deferred earnings but taxable withdrawals and no up-front write-off. It is still available for people who fail to meet the income cutoffs for the other two IRAs.
With all three IRAs, you can withdraw cash without owing the 10% early-withdrawal tax penalty if you are buying your first home (subject to a $10,000 limit), funding a college education for yourself, your spouse, your children or your grandchildren (no income limit) or are paying for medical expenses that exceed 7.5% of your AGI. And all three offer penalty-free withdrawals for any reason starting at age 59 1/2.
But the Roth has two key withdrawal advantages. Deductible and nondeductible IRAs require you to start pulling out your money at age 70 1/2. With Roths, you may leave your money untouched as long as you like. Also, since you contribute after-tax money to a Roth, you can withdraw your contributions (but not your earnings) without penalty or further taxes at any time, no matter what your age. For a head-to-head comparison of the three types of IRAs, see the table above.
WHAT KIND OF IRA TO OPEN
So what's better for your new IRA dollars: a nondeductible IRA, a deductible or a Roth? That depends on your situation, of course. But here are four helpful rules of thumb:
1. A Roth IRA always beats a nondeductible IRA. If you're married and your AGI is between $50,000 and $150,000 ($30,000 to $95,000 for singles), the decision is a no-brainer. Since you aren't eligible for a deductible IRA, a Roth is your best deal. With a nondeductible IRA, you defer paying taxes on the earnings of your after-tax contributions, but a Roth means never having to pay taxes on the earnings.
2. A Roth beats a deductible IRA if your tax bracket will stay the same or rise after you retire. Because the decision between a Roth IRA and a deductible IRA boils down to taxes now vs. taxes later, one big factor in choosing between the two is how your tax bracket will change over time. Most people find their tax bracket declines in retirement because their pension, Social Security savings and portfolio income fall short of their former paychecks, according to Clint Stretch, a director of tax policy at the accounting firm Deloitte & Touche. If you think your tax bracket will fall significantly--say, from 36% to 28%--a deductible IRA will most likely put you ahead.
But if you think you have a good chance of maintaining or even boosting your income in retirement, then the Roth wins hands down. As the graph on page 81 shows, a 40-year-old investor who stays in the 28% federal tax bracket (5% state) from now until retirement and contributes $2,000 a year to a Roth IRA earning 8% annually will have $158,000 when he turns 65. That's 9% more than the $145,000 after taxes he'd get with a deductible IRA.
3. The longer you can wait to tap your ira after you retire, the more attractive a Roth becomes. Since you needn't begin taking distributions from a Roth IRA at 70 1/2, you can get a huge financial lift by keeping your retirement stash tucked away in a Roth into your seventies and beyond. If you're age 70 and earn a modest 7% a year in a Roth IRA, you can literally double your money by age 80 by leaving it there instead of withdrawing it and spending it.
What if you're over 70 1/2 and want to keep saving? A Roth IRA is your only option. With a deductible or nondeductible IRA, once you hit 70 1/2, you have to start taking money out of your account and you must stop contributing. But just as you can keep your money in a Roth for as long as you like, you can continue adding to it each year too, so long as you have earned income. Those attributes make the Roth IRA a powerful estate-planning tool for people who will work part time in retirement. "When you die, the Roth IRA will go to your beneficiary, and no one will ever have to pay income tax on the money," says John Gardner, a tax and financial planning analyst at the accounting firm KPMG Peat Marwick in Washington, D.C. (Your estate might owe taxes on your IRA, however--at a rate of 37% or higher--just as it might on any other asset you own.)
4. Roths make great sense for kids with part-time jobs. Because you can make penalty-free withdrawals from a Roth IRA to pay your child's college bills, opening one in your own name is a great way to save for tuition. But you might also consider opening Roths in your kids' names. As long as they have earned income, they can contribute up to $2,000 a year or their entire income, whichever is lower. And retirement savings are not currently factored into the federal financial aid formula, so unless the government changes its rules, your kids' IRAs shouldn't reduce the amount of federal aid they can qualify for. "Even if your kids don't use the money for college, they'll get 50 or more years of tax-free compounding for their retirement," notes Bill DeReuter, a vice president of government relations at Merrill Lynch.
TO CONVERT OR NOT TO CONVERT
If you're like the one in three American households that already has at least one IRA, you'll need to determine whether a Roth conversion will make sense. No, that's not a new kind of religious experience. It's a way to move your existing IRA into a Roth and avoid owing taxes on the withdrawals in retirement. You're eligible if your individual 1998 AGI is $100,000 or less, whether you're married or not.
Converting will sting at first: You'll owe taxes immediately on any deductible contributions you've made and on all the earnings in your account. The 1997 tax law softens the blow a bit by requiring you to pay just one-fourth of the tax bill annually for the next four years. (The amount you convert is not included in the $100,000 AGI conversion ceiling or the $160,000/$110,000 AGI ceiling for contributions.) For example, if you have a deductible IRA balance of $100,000 from a former pension rollover and stay in the 28% bracket, you'll owe the IRS $28,000 to convert, or $7,000 a year for four years.
"Converting to a Roth IRA is a huge and complicated decision," warns Michael Chasnoff, a certified financial planner in Cincinnati. "You need to run the numbers to see if it makes sense for you." A quick way to figure out whether converting to a Roth may be a good move is to see what kind of people shouldn't convert. Convert only if you can clear all of the following four hurdles:
You believe your tax rate will fall considerably in retirement. One of the most important factors in deciding to convert is your tax rate when you withdraw the money. Suppose you are 45 years old, have $50,000 in a deductible IRA that earns 8% a year and figure your tax bracket will drop from 28% now (5% state) to 15% (5% state) when you start withdrawing at age 65. You'd be smart to sit tight with your deductible IRA. That's because in 20 years you would have an after-tax balance of just $237,000, or 2% more than the $233,000 you'd be sitting on if you converted to a Roth now after paying the taxes to convert. If you expect your tax rate to rise to 31% in retirement however, you'd be better off converting now. Then your deductible IRA would be worth $200,000, or 14% less than the Roth amount.
You'll start withdrawing the money within five years. Biting the tax bullet now with a Roth conversion pays off only if you can keep the retirement account for at least five years. If you take converted money out of a Roth IRA sooner, you'll probably be hit with a 10% withdrawal penalty. In addition, because you'd be paying taxes on the conversion over the next four years, your tax rate might go up immediately--which means that you'd not only be paying taxes on the IRA now, but you'd also be paying higher taxes on all your income in the coming four years. "In general, the more years until you'll withdraw the money, the more sense it makes to convert to a Roth IRA," says Judith McMichael, a vice president of marketing at Fidelity.
You would have to raid the IRA to pay the conversion taxes. "If you use your IRA account to pay the taxes for converting to a Roth in 1998 and you are under age 59 1/2, you may suffer a special 20% early-withdrawal penalty," points out Martin Nissenbaum, director of retirement planning at Ernst & Young in New York City. That rule is in a technical-corrections bill pending in Congress that is anticipated to become law in early 1998.
Converting means you'll forfeit valuable tax breaks. The extra income you'll have to report on your tax returns from 1998 to 2001 by converting might not only raise your bracket, but it could also push your AGI over the limit for some valuable tax credits, deductions and exemptions. "Ask your tax preparer to estimate how converting will affect your total tax picture, including eligibility for child or education credits," says Nissenbaum. (For details, see the story on page 64.)
One more thing: If you think your AGI might exceed $100,000 in 1998, wait awhile. If you convert now and discover later this year that your AGI exceeds the cutoff, you'll have to roll back the money to the original IRA at tax time--a hassle. It's smarter to make the conversion decision at the end of the year, when you can better gauge what your AGI will be. Then get ready to make some bread instead of getting burned.