|The New IRA: Christmas
in August and Every Month Thereafter
by Louis Corrigan
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accumulate tax-deferred until retirement, when they are gradually withdrawn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When the money is finally withdrawn after age 59 1/2, it's taxed as regular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
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
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
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
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.
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