Tuesday, April 5, 2011

Roth IRA versus Traditional IRA: a Snapshot of Our Tax Dilemma

Should you have a Roth IRA or a traditional IRA? That's the question for many of today's savers. The answer illustrates a basic problem in America's system of taxation, one that doesn't appear likely to be fixed any time soon.

Traditional IRA. The more or less standard reasons for choosing a traditional IRA is that you can deduct the contributions now, and defer taxation until you begin withdrawals. Generally, speaking, you must wait until you're 59 and 1/2 before you can take withdrawals. You can defer withdrawals, though, and let your savings continue to grow on a tax-deferred basis until age 70 and 1/2. Then, you must begin to withdraw a minimum amount each year or face tax penalties.

You can contribute up to $5,000 a year in 2011 (or $6,000 if you're 50 or older), or the amount of your earned income, if less. You can deduct the contribution if you and your spouse (if you have one) aren't covered by an employer retirement plan. If either of you is covered by an employer retirement plan, the amount of your deduction in 2011 begins to shrink if your adjusted gross income is $56,000 or more (if single), or $89,000 or more (if married and filing jointly). To get a headache reading about the mindlessly complex rules concerning deductibility, go to IRS Publication 590 at http://www.irs.gov/publications/p590/ch01.html#en_US_2010_publink1000230433. Keep reading for a while, because the rules really do go on at some length.

The conventional wisdom is that a traditional IRA is good for people who can deduct all or most of their contributions, and are likely to fall into a lower tax bracket in retirement. In essence, the traditional IRA lets you "borrow" the taxes that would otherwise be due on the income contributed and use them for a while to generate investment returns. You'll pay taxes eventually, but eventually could be decades away. This is one of the few loans you can take that might actually make sense.

Roth IRA. The Roth IRA is funded with aftertax dollars, up to $5,000 a year (or $6,000 if you're 50 or over), or the amount of your earned income, if less. You get no deduction from your current tax bill. Note that the $5,000/$6,000 limit is a combined annual limit for all contributions to whatever traditional and Roth IRAs you might have. For example, if you have both types of accounts and contribute $2,000 to a Roth, you can't contribute more in the same year than $3,000 to the traditional IRA.

If you maintain the Roth for at least five years, you will be able to withdraw the earnings tax free beginning at age 59 and 1/2. However, you don't ever need to make withdrawals and can keep the money in the Roth accumulating tax free investment returns until the end of your life. In such circumstances, the beneficiaries you designate will be required to gradually withdraw the funds over their lives, but they won't need to pay income taxes on those withdrawals. The Roth account will be included in your estate for federal estate tax purposes, so it may be taxed in that way if you're well-off enough. But consider yourself fortunate if you have this problem. For those with a very long term perspective, the Roth is a good estate planning device.

The conventional wisdom is that a Roth IRA is good for people who expect to be in a tax bracket equal to or higher than the one they're in currently. That would mean that Roths are basically good for relatively high earners who expect to retire relatively well off. Another consideration is that Roths are administratively easier than traditional IRAs. You don't need to fuss with calculations of minimum annual withdrawals when you get older. You can take withdrawals as and when you choose, and they aren't taxed. Or you can pass the money along to your designated beneficiaries and they aren't taxed.

The Tax Dilemma. All this is well and good if you can reasonably predict what future tax rates will be. But the current modus operandi in Washington is to jury rig ad hoc short term tax provisions, where rates, deductions and other important aspects of the tax code have very limited half-lives. Most recently, the 2010 tax compromise between President Obama and the House Republicans resulted in a two-year tax cut program that will increase, rather than decrease, the federal deficit. So you can now plan as far as two years ahead. After that, it's anyone's guess where tax brackets will be. Realistically speaking, taxes will have to rise in order to bring deficits under control. But politically speaking, the likelihood of tax increases is low, but may be more likely for moderate and low income Americans than the well-off. (If you think I'm kidding, take a look at the 2010 tax compromise: the progressive $400 Making Work Pay credit was eliminated and a less progressive 2% point cut in Social Security taxes was substituted.)

When it comes to a choice between a traditional IRA or a Roth IRA, the bottom line is no one knows for sure what's best, and most likely you won't know in the future, either. Much of life involves operating on limited information in foggy conditions. One approach would be to split your contributions between a traditional and a Roth, thereby hedging your bets. Another approach is to use only a Roth. While it's more expensive to fund, a Roth is easier administratively on the back end--when you're 83 and juggling a half a dozen prescription medications, you won't want to fool around with the IRS formula for minimum required distributions from your IRA. And a Roth may be a beneficial estate planning tool if you want to leave money to someone else.

Note to the truly frugal. If you have a moderate or low income, you may actually be able to get a tax credit of up to $1,000 for contributions to a traditional or Roth IRA. The credit is available in 2011 only if your income is $55,500 if married and filing jointly, $41,625 if you file as a Head of Household, or $27,750 if single, married filing separately or a qualifying widow(er). This credit offers a dollar-for-dollar reduction of your tax liabilities, so it's worth claiming if you can (in essence, the government funds your IRA up to $1,000). It isn't easy to save at these income levels, but the 7 or 8 Americans who manage to do so can get a nice tax credit.

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