Young people and workers in low tax brackets have a lot to gain by saving for retirement in a Roth IRA. But this year, for the first time, high-income retirement savers also have access to Roth IRA accounts. And in 2010 only, investors can delay the taxes due for retirement account balances that are converted to a Roth. Here are more reasons you should consider contributing to a Roth account.
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Lock in today's low tax rates. Traditional IRAs and 401(k)s give you a tax break during the years that you save for retirement, but you have to pay taxes upon withdrawal. With Roth IRAs and Roth 401(k)s, on the other hand, you pay the taxes upfront, and distributions that are made after age 59 1/2 from accounts that are at least five years old are tax-free. To decide whether a traditional or Roth IRA is better for you, compare your current tax rate to what you estimate you tax rate will be in retirement. Those who expect to be in a higher tax bracket in retirement have the most to gain by paying taxes up front using a Roth account. "Young people should go for a Roth IRA and allow it to grow for 30 or 40 years," says IRA expert Ed Slott, founder of irahelp.com and author of Stay Rich for Life!: Growing & Protecting Your Money in Turbulent Times. "Generally, they are in a lower tax bracket than they will be later on and the upfront tax deduction of a traditional IRA is not worth as much because they are not earning as much." Roth accounts may not be as good of a deal for retirement savers who are currently in their peak earnings years and need the tax break now. If your taxes are currently higher than you think they will be in retirement, consider delaying taxation this year by choosing a traditional IRA or 401(k). Investing your retirement savings in both pre- and post-tax retirement accounts allows you to hedge your bets against future tax increases.
Greater flexibility in retirement. After age 70 1/2, traditional IRA and 401(k) account owners are required to take distributions from their retirement accounts and pay the resulting income tax each year. The penalty for failing to withdraw the correct amount is 50 percent of the amount that should have been withdrawn in addition to regular income tax. Roth IRA and 401(k) owners are not required to take annual distributions, which gives them more flexibility to time withdrawals or pass on tax-free money to their heirs.
Easier access to your money before retirement. Roth IRAs give you more flexibility to make withdrawals before you reach retirement. Roth IRA withdrawals before age 59 1/2 result in a 10 percent early withdrawal penalty and regular income tax due only on the portion of the withdrawal that comes from earnings. Like traditional IRAs, penalty-free early withdrawals are also allowed for several reasons, including college costs, health insurance premiums after losing your job, significant unreimbursed medical costs, and certain first-time homeownership costs.
More money for heirs. Beneficiaries must pay taxes on the money they withdraw from traditional 401(k)s and IRAs. But your children and grandchildren may be able to receive tax-free distributions of the money you leave them in a Roth 401(k) or IRA. "If you are never going to need this money, it makes sense to consider a Roth and let the assets grow until your children's generation," says Beth Gamel, a certified public accountant and personal financial specialist for Pillar Financial Advisors in Waltham, Mass. "You don't have to make any withdrawals and when your children have to make withdrawals, they will never be subject to tax." However, charitable contributions will typically get you a bigger tax break when they're donated from a traditional IRA. "If you are intending to leave your IRA to a charity or a nontaxable entity you ought not do a Roth," Gamel says.
Maximize tax-sheltered assets. All of your traditional 401(k) and IRA savings isn't available for spending in retirement. You must use some of the balance to pay income tax upon withdrawal. With Roth 401(k)s and IRAs, you pay the tax using money outside of your retirement accounts. "The advantage of paying the tax with assets that are outside of the tax-sheltered plan is that you get to increase the amount of assets you have in a tax-sheltered plan," says Richard Kopcke, a research consultant at the Center for Retirement Research at Boston College. Your entire Roth IRA balance can be used for retirement expenses.
Delay taxes on 2010 conversions. Traditional IRA and 401(k) account balances can be converted to Roth accounts if you pay income tax on the amount converted. Those who make transfers in 2010 can choose between paying the tax this year or paying tax on half of the income in 2011 and the second half in 2012. "This gives you the ability to spread the out the payments over a couple of years versus having to pay it all in one year," says Shelley Ferro, a certified financial planner for Ferro Financial in Metairie, La. In future years, the tax must be paid entirely in the year of the transfer.
Space out conversions. A large conversion can result in a hefty tax bill and cause a spike in income that could impact your tax bracket, Medicare premiums, or your child's eligibility for federal financial aid for college. But you don't have to roll over your entire IRA balance in a single year. Spacing out the amount you convert each year can keep your annual tax bill reasonable. "It could be very expensive to convert all of your traditional IRA to a Roth," says Timothy Parker, a certified financial adviser for Hudson Capital Management in Ridgewood, N.J. "If you can convert chucks of it at a time and keep your tax rate low, that makes more sense."
High earners are now eligible. The IRS removed the $100,000 income limit this year, which previously didn't allow many high-income taxpayers to convert traditional IRAs to Roth IRAs. Although high earners won't be able to make new contributions to Roth accounts each year, they can get around this restriction by doing a conversion each year. "You could make a nondeductible contribution to your IRA and then convert," says Slott.
Convert your 401(k) balance to a Roth. The recently passed Small Business Jobs Act of 2010 permits employees to shift part or all of their 401(k) plan balance to a Roth 401(k) within the same plan. In 2010 only, 401(k) or 403(b) plan participants who roll over their assets to a Roth are eligible to pay the tax in 2010 or include half of the income in 2011 and half in 2012. The new law also allows government 457(b) plans to add Roth accounts beginning in 2011.
There's still time to contribute. Retirement savers can contribute up to $5,000 to an IRA in 2010 or $6,000 if they are age 50 or over. You have until your tax filing deadline to make 2010 contributions. Roth IRA conversions must be made by Dec. 31, 2010, to count for the 2010 tax year. If you later change your mind about the 2010 Roth IRA conversion, you have until Oct. 15, 2011 to shift your assets back to a traditional IRA.