|Course 204: Individual Retirement Accounts|
|The Roth Advantage|
The Roth IRA has several advantages over the traditional IRA:
Roth Raises the Income Ceiling.
Granted, an investment in a Roth IRA doesn't cut tax bills today; remember, Roth IRA contributions are made with aftertax earnings. But money invested is free to multiply, unfettered by capital gains or income-tax bites along the way.
Most Ways You Slice It, a Roth Grows More.
But go for a Roth if you qualify (or consider conversion). Roth earnings are not simply tax deferred--they're tax free, forever. Provided you've held the Roth for at least five years and are at least 59 1/2 years old when you begin withdrawing from the account, you don't owe taxes on distributions. (See IRS Publication 590 for a few picky exceptions.)
Some people eligible for a deductible IRA won't want to give up the "bird in hand," that is, a tax deduction today. Keep the big picture in focus, though, and you'll notice the long-term advantages of the Roth. Those tax-free distributions in retirement are quite a boon.
Several factors determine whether the Roth is the best choice for you: age, investment return, current tax bracket, and retirement tax bracket. Enter your personal variables into an online calculator, such as Morningstar.com's IRA Calculator, and pick which IRA best suits your situation.
In general, the more time you have and the higher your expected return, the better the Roth looks. And the higher your retirement income is likely to be, the greater the advantages of a Roth. Considering that marginal tax rates are closer to historic lows than historic highs, it is quite possible that your retirement tax rate won't be any lower than it is today--it could even be higher.
So when do traditional deductible IRA contributions seem the better bet? Most often, for people in a high tax rate today--but such investors are less likely to be eligible in the first place.
Flexible Rules Mean Easier Access to Your Money.
If you take an early withdrawal from your traditional IRA, you will pay a 10% federal tax penalty plus the income tax on the taxable portion of the distribution. In the case of death, disability, or divorce, or for those individuals who need to tap the IRA to pay for certain medical expenses, it's possible to sidestep the early-withdrawal penalty. In addition, you may also avoid the 10% penalty by taking "substantially equal periodic payments," monthly or annually, without interruption, based on your life expectancy.
The money you invest in a Roth IRA, meanwhile, can be withdrawn at any time, since you paid income taxes on the money before investing it. And as long as your Roth account is at least five years old, there are four situations in which you can draw money from your earnings tax-free: reaching age 59 1/2, disability, the purchase of a first home (in which case up to $10,000 may be withdrawn), and, of course, death.
Another perk of the Roth IRA--you aren't required to take withdrawals at age 70 1/2, as you are with a traditional IRA. That means your money can grow tax-free as long as you like and be transferred in full to your heirs. (Depending on the size of your estate, however, heirs may have to pay estate taxes.)
With a traditional IRA, in contrast, your beneficiaries will pay ordinary income taxes on the account balance based on their tax brackets. An heir can avoid paying a large amount of tax up front and take advantage of compounding by taking distributions over his or her life span. Unfortunately, many people take the lump-sum payment because they're not aware of this option. The tax-deferred status of the traditional IRA can only be transferred to a spouse. If it's part of an estate and paid to children, they must pay estate and income taxes.
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