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The Power of Tax-Deferred Savings
By Richard Moore
RealMoney.com Contributor
4/3/2007 11:03 AM EDT
URL: http://www.thestreet.com/funds/maxira/10345909.html

Americans are terrible savers, and most people approaching retirement age don't have enough assets to maintain a comfortable lifestyle once they leave the workforce.

Add to this the potential looming problems with Social Security and Medicare and you can see that any attempt to save for retirement is probably a good thing.

IRAs and other retirement plans give the investor a great advantage -- tax-free or tax-deferred savings. Over long time periods, this can really boost wealth creation. For example, a portfolio growing at 10% a year that isn't taxed will grow substantially faster than a taxed portfolio growing at the same rate. If the tax rate on a portfolio's return is 25%, the portfolio will be 25% bigger after 10 years if it is not taxed.

Traditional IRAs have the added advantage that contributions to it are not subject to tax if your income falls below a certain threshold. This gives investors the ability to use money that would otherwise go to the government to partially finance their own retirement portfolios. The higher the tax rate, the better the bargain for the traditional IRA investor.

While withdrawals from traditional IRAs are taxed at ordinary income tax rates, many people are in lower income tax brackets when they retire than when they're in the workforce. If your income is low enough (less than $50,000 for joint filers for 2006), Uncle Sam may give you a direct credit on income tax of up to $1,000 if you invest $2,000 in an IRA.

One critical requirement for contributing to an IRA is that the IRA's owner must have earned income. If you spend most of your time sitting on the veranda clipping municipal bond coupons and adding up your oil and gas royalty checks, you probably won't qualify. Then again, you probably won't need one.

However, if you're like most people who go to work every day or toil at your own business, you should be eligible. (For those who are self-employed in a business with no other employees, I have found that the self-employed 401(k) is a better option.) By the way, husbands and wives can each have their own IRA even if only one has earned income.

The other limitations to IRA contributions relate to income level and whether the participants are already covered by a retirement plan at work. There is no income restriction on deductible contributions to a traditional IRA if neither husband nor wife is covered by a plan at work. However, you can't contribute to a Roth IRA if your joint income exceeds $160,000, and traditional IRA contributions are not deductible for plan participants if joint income exceeds $85,000, and are not deductible for spouses of plan participants if joint income exceeds $160,000.

Nondeductible contributions to traditional IRAs can still be made at any income level, though. Those nondeductible contributions will still grow tax-free until withdrawals commence, at which time there is a formula for deciding how much of any withdrawal is taxable. Speaking of formulas, the details of all aspects relating to IRAs are available in IRS Publication 590. If your situation is complex, IRS publications or a good tax adviser are other places to look for answers.

For tax year 2006, total IRA contributions are limited to $4,000 per person (or $5,000 per person if age 50 or more). If your earned income is below the appropriate threshold, then this earned income would be the limit for any IRA contribution. IRA contributions can be made to traditional IRAs or Roth IRAs in any combination up to the total contribution limit.

Converting to a Roth IRABy Richard Moore
RealMoney.com Contributor
4/4/2007 12:16 PM EDT
URL: http://www.thestreet.com/funds/maxira/10345911.html


Let's assume that you like the idea of saving for retirement and using a tax-deferred or tax-free method of doing so. Let's further assume that you are married, that you and your spouse are both around 40 years old, and that your total income is less than $150,000 per year. Which IRA, traditional or Roth, would be better?

First we'll discuss the basic differences. Contributions to a traditional IRA are tax-deductible in the year made. That means that our hypothetical couple can reduce their adjusted gross income by $8,000 by making the maximum contributions to their individual IRAs. If they are in the 25% tax bracket, then they will save one-quarter of the total contributed, or $2,000, on their taxes due for the year. Therefore, in addition to that savings, they only need $6,000 to fund their contributions.

There are a couple of negatives here, however. Uncle Sam requires that taxes be paid eventually and, in the case of the traditional IRA, these taxes will be paid when withdrawals are made, usually in retirement years over the age of 59 1/2. There are penalties associated with making early withdrawals (usually 10% of the amount withdrawn), but these penalties are waived in certain circumstances, such as the taxpayer becoming disabled, various financial calamities or when the withdrawal is being used to make a first-time home purchase.

Also, at age 70 1/2, withdrawals are mandated on a schedule that roughly coincides with standard mortality life-expectancy tables.

The Roth IRA reverses the timing of tax liability for the contributions and withdrawals. Contributions are not deductible in the year made. So our couple would need to have $8,000 available to make the maximum contribution. But the huge advantage of a Roth IRA, especially for younger people, is that withdrawals are not subject to tax. Over a period of 20 years, the $8,000 contribution could easily appreciate to $25,000 at a 6% rate of return. None of that amount would be subject to tax.

There are still penalties associated with early withdrawals, but those penalties are only assessed on the earnings withdrawn -- not the original contributions. There are also penalties on any withdrawals made during an initial five-year holding period. However, there are no age-related withdrawal requirements, so assets can continue to grow tax-free for life and then will pass to heirs. While the Roth IRA is part of the estate and may trigger estate taxes, the beneficiary of a Roth IRA can avoid any income taxes by following very simple rules.

Clearly, to me at least, the Roth IRA is the preferred vehicle for most people and especially for younger investors. However, there are lots of variables to be considered, including current tax rates, future tax rates and the age of the investors. And, as a practical matter, availability of capital to invest has to be considered.

In most cases, I would rather maximize a contribution to a traditional IRA than invest a smaller amount in a Roth IRA. For that reason, and also because I like to take my tax breaks now rather than later, my own personal IRA is currently totally a traditional IRA. I'm expecting, though, that I may have a future opportunity to have the best of both worlds by converting my traditional IRA into a Roth IRA.

Converting to a Roth IRA

The ramifications of converting a traditional IRA into a Roth IRA are complex and different for each individual. There are a couple of constants, however. First, we know that taxes on the amount converted will be due immediately. If those taxes must be paid from the amount withdrawn from the traditional IRA, it is almost impossible to make a case for conversion unless there is a lengthy time between conversion and retirement to make up the taxes paid.

However, if assets are available from other sources to pay the tax bill, a conversion makes much more sense. Conversion is even more attractive if tax rates in retirement are the same or higher than current rates. While it may seem unlikely that your tax rate will be higher in retirement than while you are working, inheritances could boost the size of your investment portfolio substantially. Also, let's not forget, politicians who insist on growing the government instead of the economy have a way of increasing tax rates whenever possible.

There is an income restriction on IRA conversions. Currently, adjusted gross income must be less than $100,000 (not including the conversion amount) before a conversion is allowed. Fortunately, there is good news on this limitation due to last year's tax bill. Starting in 2010, this limitation will no longer apply, and conversions that occur in 2010 will be able to have half of the taxable converted amount taxed in 2011 and the other half taxed in 2012.

Personally, because my earned income is low and most of my other income is capital gains, I might get an opportunity to convert my own traditional IRA into a Roth if the market goes against me for a year, thus keeping my taxable income at a low level. It should be noted that, in order to avoid any penalties, assets have to be held in a Roth IRA for at least five years after conversion.