This is a guest post from Robert Brokamp of The Motley Fool. Robert is a Certified Financial Planner and the advisor for The Motley Fool's Rule Your Retirement service. He contributes one new article to Get Rich Slowly every two weeks.
Want tax-free investment growth? Want more control over your retirement savings? Want to leave a bigger inheritance? If so, you should consider contributing to or converting existing retirement savings to a Roth IRA.
The biggest difference between a Roth IRA and a traditional IRA is the tax treatment of contributions and withdrawals. With the Roth, contributions aren't tax-deductible, but withdrawals are tax-free (as long as you follow the rules). For the traditional IRA, contributions might be deductible; investments grow tax-deferred, but withdrawals are taxed as ordinary income — the highest rate possible.
To decide which is best for you, start by determining if you'll be able to deduct contributions to a traditional IRA. If you're not covered by a plan at work, a contribution to a traditional IRA is fully deductible. If you are covered, then deductibility begins to phase out at an adjusted gross income (AGI) of $55,000 for single filers ($89,000 for married couples) and is gone completely at an AGI of $65,000 ($109,000). Contributing to the Roth is then a no-brainer, assuming you're eligible (see fact sheet below).
If you can deduct your contribution to the traditional IRA, you'll have to do some calculations to decide whether a traditional IRA or Roth makes the most sense. The conventional wisdom is that a traditional IRA is better if your tax bracket today is higher than what it will be in retirement. But if you're more than 10 years away from retirement, this is a guessing game. Go with a Roth for all the other benefits.
Another bonus for younger savers: Contributions to a Roth IRA can be withdrawn anytime tax- and penalty-free, even if you haven't reached age 59-1/2 (but you will pay a 10% penalty on earnings you withdraw early). So if you'll need the money before then, you can get it. Finally, there are two other important differences between a traditional and Roth IRA: There no required minimum distributions at age 70-1/2 from a Roth IRA, and you can contribute beyond that age as long as you have earned income.
Since there are no required minimum distributions from a Roth, you can let your investments grow tax-free for as long as you don't need the money. And unlike distributions from a traditional IRA, non-taxable distributions from a Roth IRA aren't included in the calculation that determines whether your Social Security benefits will be taxed, which might mean double the tax savings.
The tax treatment of IRAs is the same for owners and beneficiaries. Anyone who inherits a traditional IRA will have to pay ordinary income taxes on the distributions. Not so with the Roth. The account will still maintain its tax-free status. And nothing says “I love you” like giving someone tax-free retirement savings. (Keep in mind that all accounts, IRAs or otherwise, are subject to estate tax if the combined value of a decedent's assets exceeds the exclusion amount, which is $3.5 million in 2009.)
How much can I contribute in 2009? $5,000 (plus another $1,000 if you're age 50 or older).
Are contributions tax-deductible? No.
How are withdrawals taxed? They're tax-free, as long as you're age 59-1/2 or older and the account has been open at least five years.
Must I take money out at age 70-1/2? No.
Why is it called a “Roth”? Named after Delaware Sen. William Roth Jr. (also known for leading investigations into Pentagon overspending that uncovered the infamous $9,600 wrench and $640 toilet seat).
Why is it so good for colds? You're thinking of “broth.”
Should you convert to a Roth IRA?
A traditional IRA can be converted into a Roth IRA by anyone whose modified adjusted gross income is below $100,000. The converted amount will count as taxable ordinary income in the year of the conversion (unless the IRA contained non-deductible contributions). But for many people, that one-year tax bite is worth the subsequent years of tax-free growth.
Here are the factors to consider:
- Generally, convert only if you can pay the taxes from sources other than the converted funds, especially if you're younger than 59-1/2 and will have to pay a 10% penalty on the money you withdrew to pay the taxes.
- If you're near retirement and you expect to be in a much lower tax bracket, the conversion probably won't be worthwhile. This is also true if the conversion will push you into a higher bracket than where you'll be when you take money out of the Roth.
- If you're in a lower tax bracket now but required minimum distributions at age 70-1/2 will push you into a higher bracket, converting portions of your traditional IRA to a Roth over a few years (partial conversions are okay) might smooth out your taxes.
- If you expect to pay estate taxes, a conversion will save your heirs money because the taxes you pay today will reduce your estate, and assets in a Roth for your heirs will be subject to estate taxes, but not income taxes.
Want some help crunching the numbers? Fiddle around with the calculators on The Motley Fool retirement page.
For more information on the wonders of the Roth, check out the Get Rich Slowly series on Roth IRAs: What is a Roth IRA and why should you care?, How to start a Roth IRA (and where to do it), Which investments are best for a Roth IRA, and Questions and answers about Roth IRAs.