Roth or Traditional IRA -- that is the question.
Sep 15 '00 (Updated Oct 03 '00)
"Why is the Roth better than the Traditional?"
"Why should I convert my IRA to a ROTH?" -- these are the questions that many of my friends and colleagues ask. I will try to answer them here. The main idea is that you get to put more money into the tax-advantaged account with the Roth IRA, so you should use the Roth whenever possible.
The Basics
Both IRAs allow you to put $2,000 a year into a tax-advantaged account for use at retirement. The difference is when you get the tax-advantage. With the traditional IRA, you can deduct your IRA contribution, thus making your contribution with "pre-tax" dollars; however, you do have to pay taxes when you withdraw the money. With the Roth IRA, on the other hand, the contribution is not tax-deductible, i.e., you contribute "after-tax" dollars; but, you pay no taxes at withdrawal.
The Limits
There is another difference between the Roth and the Traditional IRAs -- the taxable gross income (AGI) limits. You can use the Roth if you income is under about $95K/year for singles/$150K - married (the figure increases annually with inflation, and your contribution phases out gradually for incomes under $115K -- singles/$160K -- married). The traditional IRA has a much lower limit -- only $31-41K for single, and $51-61K for married people.
This means that many people are not even eligible for the deductible traditional IRA, so it's not really that difficult to "choose" the Roth. However, you can get a traditional IRA even without being eligible to contribute to it. For example, you could have had it prior to 1998 (when the Roth started); or, you could have your employers 401(k) plan rolled over to an IRA; or, you could have inherited an IRA from someone else. In all these cases a question arises whether or not to convert, and why. Remember that you can only do a conversion from a traditional to a Roth IRA if your income is under $100K.
Why Is Roth Better?
So, what's the difference between the Roth and the Traditional? Does it really matter when you pay the taxes? With the Roth you pay the taxes up front; with the traditional you pay the same taxes (income taxes, not capital gains) at withdrawal. Everyone knows that it's better to pay taxes later rather than earlier, so it's clear that the Traditional is better, right? Wrong!
The difference is that you can save more money with the Roth. With the traditional IRA you are allowed to contribute $2,000 per year, but part of that money will be taken in taxes. If you are in a 28% tax bracket, you are only contributing $1,540 in after tax money -- the other $460 will be given back to the government when you pay the taxes at retirement. With the Roth, you pay the taxes first, and contribute $2,000 after tax, of which you will get the full $2,000 at retirement. In effect, the Roth let's you contribute more money to essentially the same program.
What about conversions? The same principle applies. Suppose you have a $100,000 traditional IRA, and you are in a 28% tax bracket. That really means that you will only get $72,000 from your IRA after tax. If you convert to a Roth, you will be able to put the entire $100,000 into a tax-free Roth. You will have to pay $28,000 in taxes now, but that is in effect the same as putting $28,000 more into your IRA. And the government lets you do it!
More Roth Advantages
Here are some other advantages of the Roth:
* Tax-free income distribution to your heirs at death.
* If you have earned income after age 70, you can keep putting money in your Roth IRA. You can't contribute to a traditional IRA.
* You never have to take distributions. With a traditional IRA, you are required to take minimum distributions (and pay taxes on them) each year.
Considering Conversions
From all of the above it would seem that everyone should convert, no questions about it, right? Well, not quite. The problem is that you have to pay taxes when you convert.
Suppose you have $100,000 in your traditional IRA, and you are in a 28% tax bracket. If you convert, you will have to pay $28,000 in taxes, and that's just the federal taxes. If you have that money, then you should probably convert. However, if you don't have it, you might consider taking part of your $100,000 IRA and paying the taxes with that. That is not advisable: not only will you have to pay the taxes, but you will also have to pay a 10% early withdrawal penalty on the money you'll need to take out to pay the taxes.
Conclusion
The Roth is better if you are choosing which one to contribute to. For conversions, only choose to convert if you can pay the taxes out of pocket, not out of your IRA.
 |
|
|
|
|
|
|
Epinions.com ID:
refmaker
|
|
Member: Katya Dolginova
Location: Cambridge, MA
Reviews written: 6
Trusted by: 3 members
|
|
|
© 1999-2009 Shopping.com, Inc.