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Are You Too Old for a Roth IRA?

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Now that anyone who has a retirement account has the ability to open a Roth IRA, some investors who were previously locked out of Roths due to income restrictions have jumped at the chance for a lifetime of tax-free growth. Others, though, are still weighing whether converting to a Roth really makes sense for them.

As I wrote about yesterday, one of the most common reasons why a Roth conversion might not be the best move is if you believe your tax rate will drop by the time you need to start taking money out of your retirement accounts. But that's not the only reason. Today, let's take a look at another concern: whether older investors whose time horizons are shorter than younger investors' get enough out of a Roth to justify converting.

The benefit of time
Many see Roth IRAs as a perfect investment vehicle for younger people, and with good reason. Those who are just starting out benefit in a number of ways from using Roth IRAs:

  • They'll get the benefit of not having to pay taxes on investment income and capital gains for the longest possible time.
  • Typically, they earn less than those who are further along in their careers, meaning that they're typically in lower tax brackets. That in turn reduces the tax cost of converting.
  • Roth IRAs make it easier to take out at least part of your money before retirement if you need it for other purposes. With common expenses like making a down payment on a home creating major challenges for young people, withdrawing Roth contributions on a tax-free, penalty-free basis might not be ideal, but it's better than paying penalties to get at a traditional IRA.

On the other hand, older investors may not get much from these advantages. With only a limited time left before retirement, they may not benefit as long from tax-free treatment. Those who haven't yet retired may be at their maximum earning potential, therefore paying the most in taxes that they ever will. And once you reach age 59 1/2, you're old enough to take out IRA money penalty-free for whatever purpose you want.

The worst thing that can happen
Another concern among those with short time horizons is that if the markets move against you, converting a Roth at the wrong time can cost you much more in taxes than you would have paid in a traditional IRA. And the shorter your time horizon is, the more likely it is that you won't be able to wait out a market downturn.

The past 10 years offer a perfect example. Let's look at someone in a similar situation to yesterday's example, but who owns a different set of stocks. Assume you had $10,000 invested in each of the following seven stocks back in 2000:

Stock

Total Return Since 2000

$10,000 Invested in 2000 Is Now Worth

Walt Disney (NYSE: DIS  )

(11.3%)

$8,870

Verizon (NYSE: VZ  )

(17.0%)

$8,300

Merck (NYSE: MRK  )

(22.2%)

$7,780

General Electric (NYSE: GE  )

(53.7%)

$4,630

Texas Instruments (NYSE: TXN  )

(55.6%)

$4,440

Cisco Systems (Nasdaq: CSCO  )

(57.0%)

$4,300

Time Warner (NYSE: TWX  )

(78.5%)

$2,150

Source: Yahoo! Finance. As of Jan. 26.

Your $70,000 portfolio would now be worth just over $40,000. If you'd converted to a Roth back in 2000, you would have paid taxes on the full $70,000 amount. If you had kept those losing investments in a traditional IRA, however, you'd only pay tax on the $40,000 that was left if you withdrew it all right now. Even if you're in a higher tax bracket now, your total tax bill is likely to be a lot lower now -- and you had 10 extra years before you had to pay it.

Of course, if those losses happen right after you convert, you can simply recharacterize the Roth conversion and start over. But if the losses come after the deadline for recharacterizing passes, then you're stuck. And without a long-enough time horizon to wait out a market decline, older investors can't afford to wait for things to get better.

Weighing the possibilities
On the other hand, Roths have certain advantages for older investors, such as the fact that you don't have to take required minimum distributions as you do with regular IRAs. Yet if you're planning to spend your Roth money anyway, that's not worth as much as it is for those who expect to leave their IRA money to their heirs.

Age is just one among several factors in deciding whether a Roth is right for you. Tomorrow, I'll take a look at another key element in the Roth decision: whether converting to a Roth will force you to give up other valuable tax benefits.

Tune in for the rest of this series on evaluating whether you're better off sticking with your current retirement plan rather than converting to a Roth.

Fool contributor Dan Caplinger is far from being too old for a Roth. He owns shares of General Electric. Walt Disney is a Motley Fool Inside Value recommendation and a Motley Fool Stock Advisor selection. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy will last longer than Dorian Gray.


Read/Post Comments (4) | Recommend This Article (17)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 27, 2010, at 2:50 PM, profittkr wrote:

    The 800 lb gorilla in this discussion that nobody mentions is - how long do you think it will be before the thieving politicians decide that they need to tax Roth money twice? Given the current all out focus on soaking it to the rich to avoid offending the greatest # of eligible voters, I can assure you its in a suggestion box, somewhere. With the financial pressures on the government growing ever larger, the gutless cowards will be eying this pool of money sooner rather then later; probably as soon as they entice many to convert to it and before we get to toss Obama out of office.

  • Report this Comment On January 28, 2010, at 11:38 AM, oldfart139 wrote:

    You are still stating that the entire amount of an IRA conversion is taxable, but the contributions of after-tax dollars are NOT ... ONLY THE GROWTH. And in my IRA, much of that vanished in the 2008 debacle.

  • Report this Comment On May 04, 2010, at 2:27 PM, CrazyDay123 wrote:

    Yea. Many of us lost a lot in 2008 following all the de-regulation and under the table dealings that went on before we got to toss Bush out of office. (After he lied his way into office remember)

  • Report this Comment On May 06, 2010, at 12:47 AM, thidmark wrote:

    ^^

    Huh???

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Dan Caplinger
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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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