Some general rules:
1. Roth IRAs always beat nondeductible IRAs.
A Roth IRA lets you contribute funds that grow tax-free and are not taxed upon withdrawal after five years. With a non-deductible IRA, the gains grow tax-free, but you face income tax when you withdraw the funds.
2. Roth IRAs sometimes beat deductible IRAs.
This is more of a toss-up. That deduction is cash in your pocket this year, rather than when you're old. But if you can afford to surrender the tax deduction, you may see big Roth tax benefits later on — plus it's easier to get your money out early without penalties.
3. You can convert a regular IRA to a Roth with no penalty. You'll owe income tax on the earnings portion of the old IRA and on the principal (if the old IRA was deductible); but it's still a good idea for most. If you convert before the end of this year, you get four years to pay any incurred taxes.
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Ira Robbins founded Trouser Press magazine. Ira Levin wrote Rosemary's Baby. Ira Kaplan started Yo La Tengo. Ira Gershwin wrote all the words for George. Ira's hot dogs fed me and my friends throughout junior high. So it stands to reason that Individual Retirement Accounts are America's best retirement investment option, and since you're here in Tripod's financial section, you've perhaps already investigated, chosen, and funded an IRA.
But it's not so simple as it once was, thanks to the tongue smooch Uncle Sam has laid on Americans in the form of the Roth IRA. There are now three kinds of IRAs: non-deductible, deductible and Roth. Anyone with earned income — working for someone else, self-employed or alimony — can invest up to $2,000 a year in an IRA ($4,000 for married couples).
| Roth IRAs are a great innovation for younger investors because the no-tax-upon-withdrawal break is bigger the longer you have the thing. |
So just why should you kiss your money goodbye for 30-some years? The main reason is that all IRAs grow tax-deferred. That means that investment gains aren't taxed until withdrawals are made (and sometimes not even then).That's a big deal, as this example will show. Suppose two investors, Harvey and Joyce, each begin investing $2,000 a year at age 30. They buy the exact same mutual fund, which returns 10 percent a year, and both are in the 28 percent tax bracket. Harvey invests in the fund through a regular brokerage account, while Joyce sticks it in her IRA. By the time they retire at age 60, Harvey's account has grown to $211,000 — not bad for an investment of $60,000.
But Joyce's $60,000 investment is now worth $376,000. That extra $165,000 will be more than enough to pay her taxes when she starts withdrawing (and she won't have to pay then if she's got a Roth IRA; see below). This benefit, called tax-deferred investing, works for all IRAs. As if you're not already convinced, there's another benefit to an IRA: Certain investors are eligible to deduct contributions from their gross income, via a tax-deductible IRA.
If you (and your spouse, if you got one) are not eligible for a retirement plan through your job, you can deduct the whole IRA contribution, regardless of how much you earn. If you make $20,000 and put $2,000 into an IRA, you'll be taxed as though you earned $18,000. That saves you $300, since you'd be in the 15 percent tax bracket. If you do have access to a retirement plan, you can still deduct your full IRA contribution, so long as your income is under $30,000. If it's $30,000 to $40,000, you get a partial deduction; over $40,000 and you're out of luck.
But you still get the benefits of tax-deferred compounding, so an IRA is still the clear best choice for retirement savings.
IRAs are for long-term investing, so the government has erected all sorts of obstacles to early withdrawals. That means a 10 percent penalty if you raid your account before you turn 59 and 1/2, plus the taxes on the gains, plus an accounting headache.
But remember, it's your money, and it's there for you if you really need it. Plus, as of this year, you can now take up to $10,000 out penalty-free to use on a first-time home purchase, higher education expenses, or to pay medical expenses that total more than 7.5 percent of your adjusted gross income or health insurance if you've been unemployed.
The big new innovation is the Roth IRA, named for Delaware's other senator, William Roth. Roth IRAs are never tax-deductible; anyone with an adjusted gross income (AGI) under $95,000 ($150,000 for couples) can contribute up to $2,000 ($4,000 for couples). The Roth has a couple big advantages for those investors who aren't eligible for the tax deduction through an IRA because their income is too high.
For one, contributions to a Roth IRA are never taxed, even upon withdrawal, so long as you've had the account open more than 5 years or are older than 59 and 1/2 (or if you use the dough for a first-time house or college payments). Better still, contributions (but not gains) can be withdrawn penalty-free at any time.
Roth IRAs are a great innovation for younger investors because the no-tax-upon-withdrawal break is bigger the longer you have the thing. Plus, it's less punitive to those who need their money earlier for one reason or another — after five years, you can withdraw up to $10,000 tax- and penalty-free for purchase of a first home.
Read more Tripod columns by Ken Kurson.
Ken Kurson, 29, is an editor at Esquire magazine, a regular commentator on CNNfn, and was formerly an editor at Worth magazine, where he wrote the popular "Advocate" column. Kurson is also the author of The Green Guide to Personal Finance : Money Matters in Your Twenties and Thirties, published by Main Street Books. His money zine, "GREEN: PERSONAL FINANCE FOR THE UNASHAMED," is published quarterly and is available for $3 an issue or $10 for a year's subscription. For more information or to subscribe, write GREEN at 245 8th Avenue, Suite 286, New York, NY, 10011.
© 1998 Ken Kurson, All Rights Reserved.
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