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It's hard to argue with the appeal of the Roth IRA: Sock away post-tax dollars now, then withdraw your years of accumulated growth tax-free in retirement! Unfortunately, most investors don't realize that the rules now enshrining that promise of tax-free goodness could change at any time.
Before you laugh off that notion, remember that Social Security benefits weren't always taxable. Amendments to the Social Security Act back in 1983 introduced that wrinkle. Today, depending on your means, part or much of your Social Security benefit may be taxable income to you.
Tax rules change over time. Rates have gone up and down throughout history, on both incomes and our investments. Various credits and deductions come and go. In the Roth's case, means-testing could leave wealthier accountholders paying taxes on at least some of their withdrawals.
Pluses and minuses
There's no question that investing in an IRA makes a lot of sense for most of us. It's a great wealth-building tool with considerable tax advantages. But the benefit of the traditional IRA -- deduct your contributions now, pay taxes on withdrawals in retirement -- is immediate and certain, while the Roth's is back-loaded and less certain.
For young people with decades ahead to grow their nest eggs, the Roth is especially compelling. Since they may end up with sizable retirement accounts, the equally large tax savings they might stand to gain could make the Roth worth the gamble.
The decision is never clear-cut, though. If you're in a steep tax bracket now, and you expect to be in a low one come retirement, a traditional IRA might make more sense. Conversely, if you foresee overall income tax rates rising significantly for everyone, then the possibility of tax-free withdrawals from a Roth could be more attractive.
The toughest decision may face those considering converting a traditional IRA into a Roth. You can do so, but you'll probably have to pay taxes on the amount you convert, since you likely got a deduction when you plunked it into the traditional IRA. Dealing with big lump sums rather than gradual contributions over time can make this decision even tougher. The current annual contribution limit for traditional and Roth IRAs is $5,000 for most of us, and $6,000 for those 50 or older. But you might have $100,000 or more stashed in a traditional IRA that's been growing for years. Converting all of that into a Roth could stick you with a tax bill for tens of thousands of dollars.
That big bill can be worth it if your $100,000 grows well over time, leaving you with bushels of tax-free withdrawals. But if the rules change, you'll have paid taxes on the conversion only to face taxes again upon withdrawal.
I'm not suggesting that you rule out the Roth. It's far too powerful, at least potentially, to deserve that. Just factor in the possibility of rule changes when making your IRA decisions.
You might decide to fund both kinds of IRAs; opt to convert only part of your traditional IRA assets; or even re-convert a Roth IRA into a traditional IRA at some point in the future. (The IRS is cool with do-overs, as long as you play by the rules.)
Uncle Sam giveth, and Uncle Sam taketh away. But no matter what the government decides to do, you can keep more of your dollars if you take the time to learn the tax rules, and plan your money moves carefully.
True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.
Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article. Try any of our investing newsletter services free for 30 days. The Motley Fool is Fools writing for Fools.