The joy of tax-free retirement income
New rules will soon allow many more retirement savers to have a Roth IRA. My advice is go for it.
(MONEY Magazine) -- For the first time since Roth IRAs were introduced almost 10 years ago, politicians are finally ready to give everybody the chance to save in these accounts.
In May, Congress eliminated the restriction barring anyone who makes more than $100,000 from converting a traditional IRA to a Roth IRA. Now no matter what your income is, you'll be able to enjoy the chief benefit of a Roth: tax-free income when you retire.
Call me a Roth-o-maniac, but I think you should probably take Washington up on the offer.
A couple of notes: First, the new provision doesn't kick in until 2010. Second, the new law dealt only with conversions, leaving in place rules that prevent you from contributing to a regular Roth account each year if your income is $110,000 or more ($160,000 for couples).
But there's an easy way around this. Just open a nondeductible IRA - which anyone with earned income can do - and then convert it to a Roth.
So by 2010 everyone will be able to have a Roth one way or another.
The Extra Roth Advantage
You've probably already heard that you're better off with a Roth if you expect to be in a higher tax bracket at retirement. By investing in the Roth, you are paying taxes today, when your rate is lower, and avoiding a tax bill later, when your rate is higher.
But a Roth can also be the better deal if your tax rate stays the same, which is the more likely assumption.
Here's why Say you have $5,000 to invest (the $4,000 max for an IRA this year, plus the $1,000 catch-up for people 50 or older), and assume that your account will earn 8% a year and that you'll be in the 25% tax bracket before and after you retire.
Put your five grand in a Roth, and you'll have $23,305 tax-free after 20 years. If you put your five grand in the traditional IRA instead, it will grow to the same sum, but you'll owe $5,826 in taxes when you withdraw the money, reducing your account to $17,479.
But don't you also get a tax deduction with the traditional IRA? Yes, you do; in this case it's worth $1,250, or 25% of your $5,000 contribution. If you invest that tax savings at 8% a year, after 20 years it will total $5,826. Add that amount to your after-tax balance and you've got $23,305, same as with the Roth.
So it's a wash, right?
Actually, no, and here's why. Even if you were diligent enough to invest your tax savings rather than spend it, you'd have to put that money in a taxable account since you'd already have hit the annual limit on IRA contributions. So you'd have to pay taxes on income and realized gains in that account, producing a lower return, after taxes, than the totally tax-free 8% you'd earn in the Roth.
Bottom Line When you're contributing the max, the Roth has the distinct edge since more of your money grows without the drag of taxes. The advantage is sometimes so large that a Roth remains the better option even if you move to a slightly lower bracket in retirement.
And the same generally holds true when you compare contributing the max to a Roth 401(k) vs. a regular 401(k) and when you consider converting a traditional IRA to a Roth.
Hedging Your Tax Bets
Even if you think you'll move into a much lower tax bracket after you retire - the one situation in which a traditional IRA seems the clear winner - there are compelling reasons to consider a Roth for at least some of your retirement money.
For one, you can't really count on your tax rates dropping in retirement. If you travel a lot or live a particularly comfy lifestyle, your withdrawals from retirement accounts could easily be high enough to keep you in the same bracket that you're in now or knock you into a higher one.
Another tax wild card: Congress. Given the size of the budget deficit, it's hardly a stretch to imagine that future legislators might raise tax rates, which could sharply reduce the after-tax value of the money you have stashed in traditional IRAs and 401(k)s.
By funding a Roth, you hedge against the possibility of higher rates by ensuring you'll have some savings that won't be subject to income taxes at all.
Roths have another nifty advantage. With a regular IRA, you have to take distributions after age 70½. Roths have no such rules, which means you can let your entire balance grow without taxes for the rest of your life if you wish - and pass on the tax-free gravy train to heirs.
So if you qualify for any type of Roth, think seriously about setting one up. And if you're still not eligible, well, 2010 isn't really that far away.