When it comes to opening an individual retirement account, should you go with a traditional IRA or a Roth? Traditional IRAs and Roth IRAs have their own unique benefits, but new rules in 2010 allow some investors who had been locked out of Roth IRAs the option to take advantage of Roth’s tax-free withdrawals. Whether you’re just starting to save for retirement or considering rolling over a traditional IRA, here are a few things to know about Roth IRAs:
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Tax-free withdrawals. Roth IRAs, like traditional IRAs, provide tax-free growth over the life of your investment. But when you invest in a Roth IRA, the only time you pay taxes is when you make your initial investment (with traditional IRAs, you pay taxes when you withdraw the funds). “It’s like a municipal bond on steroids because you can invest it in high-yielding, high return-potential assets like stocks, and turn them into tax-free assets,” says Mark Joseph, a financial adviser at Sentinel Wealth Management in Reston, Va. For younger investors, that means a small initial investment can snowball over the years into a hefty sum by retirement age.
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Tax rate hikes. Many experts in Washington are worried that rising deficits are going to force Congress to raise taxes. If you invest in a Roth IRA before any potential rate hikes, you can take advantage of current tax rates. “Right now, we have this huge debt and we have this huge amount of money that’s going to pay for social security benefits,” says Ray LeVitre, a financial adviser with Net Worth Advisory Group in Midvale, Utah. “It makes sense to say, ‘they’re going to have to raise taxes.’” If taxes go up in the future, your investment won’t be affected because only your initial investment in a Roth is taxed.
Tax diversification. You already know that it’s important to have a diversified portfolio of investments. The same applies to taxes. “You’re not going to be 100 percent right or 100 percent wrong about where tax rates go so you should put some in both,” LeVitre says. He suggests splitting your retirement money between a Roth IRA and a traditional IRA. When you invest in a Roth IRA, you’re betting that by the time you take your money out, you will be in a higher tax bracket. The logic is reversed with traditional IRAs. “For someone in a low tax bracket, it’s a no-brainer,” LeVitre says. He considers a “low” tax bracket one that falls within the first three levels of brackets (those taxed at a rate of 10 percent, 15 percent, or 25 percent).
New conversion rules. In the past, anyone making more than $100,000 a year couldn’t convert their traditional IRA into a Roth. Starting in 2010, individuals making more than $100,000 can transfer their money into a Roth IRA. Check with a financial adviser to see if rolling over your traditional IRA into a Roth IRA makes sense for you. For one year only, investors can convert to a Roth and pay one half of the taxable amount in 2011 and the other half of the taxable amount in 2012 instead of being taxed for the full conversion in one year alone.
Passing wealth on. Another benefit of Roth IRAs is the option to hold on to the Roth indefinitely. Traditional IRAs require investors to begin withdrawing a minimum amount after age 70 1/2. There are no minimum withdrawals required for a Roth IRA, so you can take advantage of tax-free growth for as long as you like. You can preserve your estate and pass your investments in your Roth IRA to your beneficiaries tax-free.
Corrected on 02/12/10: An earlier version of this article misstated the years you convert to a Roth IRA and split up the tax payments. Investors can pay one half of the taxable amount in 2011 and the other half of the taxable amount in 2012.
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