Key Points
The Roth IRA presents a potentially attractive alternative to the
traditional 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.
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 total annual contributions to all IRAs are limited to
$5,000 in 2011. Individuals who are at least 50 years old
by the end of the year 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. The contribution
limit begins to decline or "phase out" for single taxpayers with
adjusted gross incomes (AGIs) of more than $107,000 and for married
couples filing jointly with AGIs of more than $169,000. Individuals
with AGIs in excess of $122,000 ($179,000 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.
Contribution limits may increase in the years
ahead. In the future, the annual contribution limit may be
adjusted for inflation.
Your contributions to a Roth IRA may continue beyond age
70½. You are not required to start taking
distributions from a Roth IRA at age 70½, 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 traditional IRAs.
Qualified distributions from a Roth IRA are tax
free. While your contributions to a Roth IRA are never tax
deductible, your distributions may be tax free if you have owned
the Roth IRA for at least five years and:
- You are at least 59½ years old or you qualify for one of
several exceptions; or
- Your withdrawal of up to $10,000 (lifetime limit) is applied to
a first-time home purchase; or
- You die or become permanently disabled.
You may qualify for the "first-time home purchase" if you have not
owned a home for at least two years before the date on the purchase
contract or the date when construction started. You, your spouse,
or a descendant or ancestor of either may qualify as the
buyer.
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.
Penalty-free withdrawals are permitted for qualified
education expenses. If you are under age
59½ but have held the Roth IRA for five years, you may
withdraw funds penalty free to pay for qualified education expenses
for yourself or family members. You will have to pay income tax on
the taxable portion of the distribution, however.
Retirement plan "rollovers" are permitted. 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. In the past, you could do this only if your workplace
retirement account was a Roth-style plan. But since 2008, direct
rollovers from a non-Roth plan have been allowed. The rollover is
treated as a conversion, with income taxes due on all proceeds.
The Traditional IRA vs. the Roth IRA
When deciding whether a traditional 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 traditional IRA will be taxed.
For those whose contributions to a traditional IRA are tax
deductible and who are in a higher tax bracket today than they will
be in during retirement, a traditional 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
traditional IRA regardless of your income level, up to $5,000 in
2010 (or $6,000 if you are at least 50 years old). Deductible
contributions may be reduced or eliminated for individuals who
participate in a company-sponsored retirement plan, based on their
incomes.
| The Traditional IRA |
| The traditional IRA may still provide an advantage over the
Roth IRA to those who maximize its benefit. Here's how: You invest
the tax savings from your IRA deduction in a traditional account
each year and let that account grow along with your IRA. Assuming
your tax rate drops in retirement, this could yield more of a
tax-adjusted benefit than a Roth IRA. |
Conversion of a Traditional IRA to a Roth IRA
There are no income limits associated with the conversion of a
traditional IRA to a Roth IRA - anyone can convert, provided they
pay the tax bill. 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. Note that for
conversions completed in 2010 only, taxpayers were permitted to
spread this tax bill out over a two-year period. If you have a
nondeductible, traditional IRA, its earnings will be taxed but the
amount of your contributions will not. The withdrawal from your
traditional IRA will count as income but will not trigger the 10%
penalty usually imposed on early withdrawals.
Which Is Right for You?
If you have a traditional 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 traditional IRA contributions are
nondeductible, you may be better off with a Roth IRA.
That's because the distributions of earnings from your traditional,
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 traditional 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.
Points to Remember
- Roth IRA contributions are nondeductible, but qualified
withdrawals are tax free.
- Individual contributions to all IRAs are limited to $5,000 in
2011 ($6,000 for investors who are at least 50 years old). Note
that this amount will increase in the years ahead.
- You may continue contributions to a Roth IRA after age
70½, and there are no mandatory withdrawals.
- You can make penalty-free withdrawals from a Roth IRA before
age 59½ for a first-time home purchase or if you die or
become permanently disabled.
© 2011 McGraw-Hill Financial Communications. All rights
reserved.
