MainBanner JavaFiller
quote.fool.comToday's FeaturesQuotes, News, Charts, Data

Nothing dispels enthusiasm like an admission fee. -- Kin Hubbard

The New IRA: Christmas in August and Every Month Thereafter
by Louis Corrigan (RgeSeymour)

ATLANTA, GA (Aug. 13, 1997) --The new tax law should have investors pulling out their calculators or scheduling appointments with their financial planners. That's because in addition to the cuts in capital gains taxes that make buy-and-hold investing more attractive, the law ushers in a brand-new Individual Retirement Account (IRA) that should prove a boon to anyone investing for the long haul to pay for retirement, a first house, or a college education. In fact, the new tax-exempt Roth IRA, frequently called the IRA Plus, is so attractive to investors looking to generate long-term savings that many people may benefit from taking a tax charge now to roll their existing IRA balances into the new accounts.

A conventional IRA allows most workers to make an annual tax-deductible contribution of $2,000 ($4,000 for couples) to an account in which savings accumulate tax-deferred until retirement, when they are gradually withdrawn and taxed. Such IRAs have three main advantages over just plugging money into your typical brokerage account or mutual fund. The upfront tax break amounts to a government subsidy to your savings; you're literally getting to invest a few hundred dollars that would otherwise go the Internal Revenue Service (IRS). The deferral of taxes permits these savings to accumulate more rapidly since they aren't subject to capital gains taxes over the years. When the money is finally withdrawn after age 59 1/2, it's taxed as regular income. By then, though, an investor is usually in a lower tax bracket.

Conventional IRAs have a couple of limitations. For one thing, there's a 10% penalty for early withdrawal. Also, full deductibility of the $2,000 annual contribution has been restricted to people who don't participate in an employer-sponsored retirement plan. For workers covered by a 401(k) or other pension plan, IRA contributions remain tax-deductible only for individuals with annual income below $20,000 or couples with income below $40,000. People with higher annual incomes can still stow away money in an IRA to take advantage of the tax-deferred accumulation of assets, but they miss out on the upfront tax break.

Even so, with about 70% of working Americans eligible for the full deductions, IRAs have been a good deal for small investors, despite the fact that relatively few people (about 5% of all workers) contribute to them. The new tax law sweetens the prospects by raising the income limits and easing the restrictions on withdrawals. Next year, participants in corporate retirement plans can make fully deductible $2,000 contributions to these traditional IRAs if their gross adjusted income is less than $30,000, or $50,000 for those filing a joint return. Those thresholds will rise to $40,000 and $80,000, respectively, by 2004. Plus, a non-working spouse married to someone with a company retirement plan will now be allowed a fully deductible $2,000 IRA contribution as long as the couple doesn't make more than $150,000. Finally, these savings can now be withdrawn without penalty to buy a first house or pay for education.

The Roth IRA, however, may offer an even better deal. This new account differs from the conventional IRA in that it provides no tax advantage upfront on contributions. What it offers instead is total exemption from federal taxes when one is ready to cash out to pay for retirement, a first house, or education. In addition, the higher income restrictions of $95,000 for individuals and $150,000 for couples make the Roth IRAs particularly appealing to taxpayers who participate in corporate retirement plans and don't qualify for deductible contributions to the conventional IRA. They won't get the tax deduction but will benefit tremendously from the shift from tax-deferred to tax-exempt savings.

The main caveat with the Roth IRA is that profits can't be withdrawn from these accounts without a penalty for at least five years. On the other hand, an investor can take out the value of all initial contributions at any time without being penalized. Plus, there are no mandatory distributions beginning at age 70 1/2, making the Roth account an ideal vehicle for an investor looking to become the most beloved ancestor in his or her family.

Since taxpayers can only contribute $2,000 a year into any IRA (plus the $500 per child annual allowance for the new tax-exempt education IRAs, which work like the Roth account), the first question for most investors is whether to put new contributions into an old tax-deductible account or a new Roth IRA. Financial planners are only now doing the preliminary analysis. Conclusions will no doubt differ based on an individual's particular circumstances. Still, the experts suggest that folks who are now in a high tax bracket but expect to retire into a lower bracket may well be better off sticking with the old IRAs and getting the sure tax benefit now rather than hoping for future investment profits to provide more of a kick down the road. On the other hand, some experts see the choice as a no-brainer, with the Roth IRA looking like a bonanza, particularly for investors with a reasonably long-term horizon.

To get an idea of the difference, consider what happens to the $100,000 in investment profits accumulated over three and a half decades from an initial $2,000 investment that turns in modestly market-beating results of 12% annual growth. If the money is in a Roth IRA, you're looking at pure tax-free profits you can take to the bank along with your upfront investment. But if you've built your nest egg in a standard tax-deductible IRA, your profits plus your initial $2,000 contribution will be taxed as regular income upon withdrawal. Someone retiring into the 15% tax bracket would have spared themselves initial tax payments of between $300 to $560 (depending upon whether they fell into the prevailing 15% or 28% tax bracket at the time). Yet now they would find themselves walking away with after-tax income of $86,700, a nice chunk of change but substantially less than what they would have with a Roth account. Those retiring into the 28% bracket would pocket just $73,440.

Of course, the Roth account requires an investor to put up more of his or her money at the beginning since the federal government isn't chipping in to help someone save. That means a $2,000 contribution to a Roth account will cost $2,000 in after-tax dollars whereas someone in the 28% tax bracket can buy a $2,000 contribution to a traditional IRA for just $1,440 in equivalent after-tax dollars, and the same deal will cost someone in the 15% bracket $1,700. If you can't afford the higher real contribution, you won't come out ahead. That's particularly true if you expect to be in a lower tax bracket when you cash out your account. For example, someone in the 28% bracket who spends just $1440 to stash $2,000 into a traditional IRA will end up, after ten years, with net savings of $5,280 if by then he or she is in the 15% bracket. The end result drops to $4,472 if the investor is still in the 28% bracket. A similar amount put into a Roth account would yield just $4,472 regardless of an investor's tax bracket upon withdrawal.

If this sounds complicated, consider the more difficult question of whether someone should convert an existing tax-deferred IRA into a Roth account. Taxpayers with gross adjusted income below $100,000 can make this switch without incurring special penalties. They will, however, be required to pay taxes on some or all of the money, depending upon whether their contributions were tax-deductible or not. So rolling over an old IRA into a new one will cost you upfront, as you settle your tab with the IRS. Still, if you make the switch before January 1, 1999, you can spread your tax pain over four years.

Will this make financial sense for you? Again, you want to consider whether you will be in a lower tax bracket when you withdraw the money from your account. It's likely you'll come out ahead, too, if you've got spare cash sitting around to pay the taxes on the IRA income you're looking to transfer. Otherwise, the tax hit will deplete your investment income, likely defeating the purpose of the switch. Another worry is that cashing out the old IRA could knock you into a higher tax bracket overall, possibly creating new troubles that would make the transfer a bad idea.

The Wall Street Journalrecently discussed one extreme example provided by Coopers & Lybrand senior consultant William Kahn. An executive in the 39.6% tax bracket looking to withdraw $100,000 from a tax-deductible IRA might have to pay the tax from his savings, transferring just $60,400 to a Roth account. But assuming 10 years of 10% growth, the executive would end up with about 20% more savings than he would have if he had kept the money in the original IRA and paid a penalty for early withdrawal plus his still high tax rate. Of course, with so many variables, our well-to-do executive could end up quite differently, depending upon what assumptions you tweak and how.

To take another extreme, consider a young investor now in the 15% bracket who expects to be in the 28% bracket five years from now. Through hook or by crook she's managed to turn a measly $2,000 IRA contribution into $10,000 in just a couple of years. Leaving this money in the old IRA and assuming a 12% annual return, it will be worth just $12,689 after taxes when she wants to withdraw it to help pay for a first home. If she can afford to pay $1,500 in taxes now out of other income and roll the entire $10,000 into the Roth IRA, she'll have $17,623 in tax-free savings to go toward her home purchase. Yet even if one assumes she must subtract the taxes from her IRA savings, she still comes out ahead by switching over to a Roth account, with $14,980 for her new house.

As many have pointed out, certified financial planners and others who help us all make sense of these matters are the clearest beneficiaries of the new tax proposal. Business should be booming. Fools might do well to either consult a professional or dig in with a calculator to see what makes the best long-term investment sense for them based on the most likely scenario. Still, the new Roth IRA (and its cousin, the education IRA) appears to offer something of a tax-free nirvana for those in position to take advantage of it. If you plan to turn your steady savings into millions of dollars over the next several decades, it's probably worth your time to take a hard look at the new IRA.

Tax Strategies message board

Retirement Investing message board