Choosing Between Roth IRAs and Traditional Deductible IRAs
The decision is complicated if you’re eligible for both types of IRAs. With the creation of the Roth IRA and the liberalized eligibility guidelines for the traditional IRA, the vast majority of individuals are now eligible to make some sort of IRA contribution.
All but the wealthiest of workers are eligible to contribute to a Roth IRA. Eligibility to make the maximum contribution to a Roth is limited to married couples with adjusted gross incomes of less than $150,000 and single individuals with incomes under $95,000. Smaller contributions are allowed for couples with adjusted incomes up to $160,000 and singles with incomes up to $110,000. Roth IRA contributions aren’t deductible, but withdrawals are tax-free once the account has been open more than five years and you’re over age 59 1/2.
Fewer taxpayers qualify for traditional IRAs, where contributions are deductible, but withdrawals are taxed. But Congress loosened the eligibility requirements to allow many more taxpayers to take advantage of traditional IRAs than in the past.
The Taxpayer Relief Act of 1997 raised the income-eligibility limits for taxpayers who participate in a 401(k) or are covered by some other employer retirement plan. Before the rules were liberalized by the 1997 tax act, a married couple above the income-thresholds could make deductible IRA contributions only if neither spouse was covered by a retirement plan at work.
But this restriction was eased beginning with 1998 returns. If only one spouse is covered by an employer retirement plan, the other spouse will be eligible for at least a partial IRA deduction so long as the couple’s joint income is below $160,000.
If neither spouse is covered by an employer retirement plan, then both spouses can make deductible contributions to a traditional IRA, no matter how high their income.
Roth IRA vs. Traditional IRA
The decision about which type of IRA to set up will be a simple one for most higher-income taxpayers who will only be eligible for Roth IRAs, but the decision is complicated if you’re eligible for both types of IRAs.
There have been numerous articles in the financial press and advertising campaigns by financial institutions extolling the virtues of the Roth IRA. All the ballyhoo has made the advent of Roth IRAs seem like the financial equivalent of the Second Coming. And indeed, many people will find that the ability to make tax-free withdrawals from a Roth IRA is a more valuable tax benefit than getting an upfront deduction for contributions to a traditional IRA.
But many people won’t come out ahead with a Roth IRA. Whether you’re likely to come out ahead with the upfront tax deduction from the traditional IRA or the benefit of tax-free withdrawals from the Roth IRA depends on your tax bracket now, your expected tax bracket in retirement, how long you plan to keep the money in the IRA, and the return you expect from your investments.
If you opt for a Roth IRA, you should expect to be in at least as high a tax bracket – preferably a higher bracket – when you retire than you are in now. But many workers can expect to end up in a lower tax bracket when they retire, since most workers’ incomes decline in retirement when they are no longer earning weekly paychecks.
How long you expect to keep the money in the IRA will also be an important factor. Roth IRAs are also well suited for savings that you don’t expect to need in retirement. The money can be kept in the Roth IRA and passed onto heirs free of income tax. In contrast to deductible IRAs, you aren’t required to make minimum withdrawals each year from a Roth when you reach age 70 1/2.
IRA contributions for the 2001 tax year can be made up until April 15, 2002.
Converting Traditional IRAs to Roth IRAs
Taxpayers with modified adjusted gross incomes of up to $100,000 have the right to convert their traditional IRAs to Roth IRAs. When converting to a Roth IRA, money rolled over from your old IRAs is partly or fully subject to tax as if it had been withdrawn. The advantage to converting is that all your future earnings will be tax-free. Roth IRA withdrawals are tax-free once the account has been open for more than five years and you’re over age 59 1/2 or are using up to $10,000 to buy a first home.
But converting is not for everyone. If you need to dip into your IRA funds in order to pay the tax on the conversion, converting isn’t advisable. Nor does it generally pay to convert if you expect to be in a much lower tax bracket when you retire, nor is converting likely to pay off, unless you plan to keep the money in the Roth IRA for at least 10 to 15 years.
Also keep in mind that converting will raise your adjusted gross income, which could limit your eligibility for some tax breaks in the year the conversion is made. Some valuable tax breaks – including the child tax credit, the Hope and Lifetime college tuition credits and the student loan deduction – are phased out for taxpayers with adjusted gross incomes above certain levels.
If you decide to convert, the tax law generally gives you until your tax return is due for the year in which the conversion was made to change your mind and undo the conversion.
Income Tax Fundamentals, 2002 Edition; Whittenburg, Altus-Buller, Pg3-14-3-17