The Many Benefits of the Roth IRA

This column is not about municipal bonds. They’re way too boring. The is about an IRA, but not just any old IRA. It’s a special IRA called a Roth IRA. The other kind of IRA is called a traditional IRA.

Here is the difference:

When you use a traditional IRA, you get to deduct your contribution up to $6,000 annually. It must come from earned income. If you are age 50 or older, you can deduct another $1,000. When you reduce your taxable income by $6,000 and you are in a 12% tax bracket, that means you have reduced your tax bill by $720. The higher your tax bracket the more you save in taxes.

But there is more.

With the traditional IRA, your investment grows tax-deferred. You pay no current taxes on the growth.

The keyword here is “deferred.” The day you start taking money out you will start paying taxes on any withdrawals. The money is added to any income and you will pay taxes in your regular income tax bracket. Be sure not to take money out before you are 59 ½ or you will pay a 10% penalty in addition to your regular tax.

You are required to take minimum distributions at age 72.

Between age 59 ½ and 72 you can take anything out you want with no penalty. You just have to pay regular income tax on it. After age 72 you can take out more than the required minimum distribution, but there is no escaping the income tax.

How can you escape taxes?

This is where the Roth IRA comes to your rescue. It doesn’t save taxes when you make a contribution. There is no tax deduction. The money you contribute is after-tax money. After that, all of your growth and all of your withdrawals are tax-free.

The way you escape taxes on a Roth IRA is to pay an “entry fee.” That is the tax you pay upfront to gain entry. You might ask, “Why would I pay such an entry fee?” The answer is because the benefit of tax-free withdrawals may be far more beneficial than the entry fee.

The amount you can contribute to a Roth IRA is the same as a traditional IRA. That is $6,000 plus $1000 for those over 50. It must come from earned income. Income from stocks, bonds, Social Security, or inheritances does not count as income.

However, remember that the amount you can contribute to a Roth IRA is limited by certain income levels. For married couples filing a joint return, the phaseout starts at $198,000. For singles and a head of household, it starts at $125,000.

A key question for many remains: Is converting your traditional IRA to a Roth IRA the right move for you?

Your decision depends on your current and future tax situations. You are trying to determine whether the tax rate you pay to use a Roth IRA today will be greater or smaller than the rate you will pay on distributions when you take them from your traditional IRA. Keep in mind that when you make a conversion you must pay taxes on the amount you are converting. You can also do partial conversions.

Here are some issues to think about when trying to make a decision. They all relate to when you could be in a lower tax bracket.

• You expect to stop working or go part-time, resulting in lower-income and possibly a lower tax bracket. These could be times you would consider doing a conversion.
• You plan on moving to a state with lower, or no, income tax.
• You plan on moving to a more expensive home with significantly more tax-deductible interest on a mortgage.
• You have significantly more deductible healthcare expenses.
• You feel that because of the high government debt there will be an increase in income taxes.
• You are younger and starting a career with a lower income.
• You are at retirement and for at least a year you will have very little earned income if any. This should be before taking Social Security, which could put you in a higher bracket.

​And ask yourself these questions:

What is my current tax situation? What do I expect my future tax bracket to be? Is it higher or lower than my current one? Will my annual income increase or decrease?

There are many detailed variables that cannot be addressed in one column. Keep in mind this is not just a numbers game. It’s also about personality and lifestyle. A good decision is based on a holistic approach. I recommend using a fee-only certified financial planner who is trained to help you look at the total picture.

Vern Hayden is a certified financial planner and the author of “Getting an Investing Game Plan.”