This is a crucial distinction because with a Roth your contributions are taxed today, while withdrawals, including investment earnings, are tax-free at retirement. Conversely, contributing to a traditional IRA lowers your current taxable income; then, in exchange for that present-day favorable tax treatment, you later pay taxes on your balance when it’s withdrawn at retirement.
Some financial experts presume that because your income will likely be lower at retirement, your tax bracket probably will drop as well. Others, more pessimistic about the current economy, predict that record budget deficits could lead to higher future tax rates.
So, how to choose? Despite their more immediate tax burden, Roth IRAs have a couple of longer-term advantages for many folks. For example:
- The younger you are when you start saving in a Roth, the longer your money will compound, tax-free.
- Unlike traditional IRAs, Roth’s have no mandatory minimum annual withdrawals beginning at age 70 ½, so your account can continue to grow tax-free during your lifetime. (Mandatory withdrawals from traditional IRAs were waived for 2009 only.)
- Heirs who inherit a Roth IRA do not pay income tax on withdrawals as they do with an inherited traditional IRA.
Either way, IRAs are still a good vehicle for retirement savings, particularly if you don’t participate in a workplace 401(k) plan. And now, thanks to two tax code changes effective January 1, 2010, you have additional options regarding IRAs.
First, people (single or married) whose modified adjusted gross income (MAGI) exceeds $100,000 can now convert part or all of their existing traditional IRAs – or workplace savings plans from an old employer – into a Roth IRA. Previously, these higher-income folks were excluded from such conversions. (Note that certain MAGI limits do still apply for new Roth contributions. See IRS Publication 590 at www.irs.gov for details.)
Although such conversions may indeed provide long-term tax advantages, they can be difficult to swallow in the short term, since the converted balance is added to your taxable income, thereby increasing your taxes – and possibly boosting you into a higher tax bracket – for the year.
That’s where the second tax-code change comes in handy: For 2010 only, you can either pay the full tax amount with your 2010 taxes (due April 15, 2011), or pay half with your 2010 taxes and half with 2011’s return.
As always, you can undo, or “recharacterize,” a conversion later on if needed. For example, if your Roth IRA balance significantly decreased after conversion (as many did after the 2008 stock market crash), you would be taxed on account value that no longer exists; so, you are allowed to undo the conversion and then reconvert at a more favorable time. Recharacterization rules and deadlines are complex, so refer to Publication 590 for details.
Better yet, always consult a tax or investment professional for help weighing your options before making any major changes to your retirement savings habits.
Jason Alderman directs Visas financial education programs. Sign up for his free monthly e-Newsletter at www.practicalmoneyskills.com/newsletter.