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The decision is complicated if you're eligible
for both types of IRAs.
With the creation of the Roth IRA
and the liberalized eligibility guidelines for the traditional IRA, the
vast majority of individuals are now eligible to make some sort of IRA
contribution.
IRA Eligibility
All but the wealthiest of workers are eligible to
contribute to a Roth IRA. Eligibility to make a full $2,000-per-person
contribution to a Roth is limited to married couples with adjusted gross
incomes of less than $150,000 and single individuals with incomes under
$95,000. Smaller contributions are allowed for couples with adjusted
incomes up to $160,000 and singles with incomes up to $110,000.
Roth IRA contributions aren't deductible, but
withdrawals are tax-free once the account has been open more than five
years and you're over age 59 1/2.
Fewer taxpayers qualify for traditional IRAs,
where contributions are deductible, but withdrawals are taxed. But
Congress loosened the eligibility requirements to allow many more
taxpayers to take advantage of traditional IRAs than in the past.
The Taxpayer Relief Act of 1997 raised the
income-eligibility limits for taxpayers who participate in a 401(k) or are
covered by some other employer retirement plan. At least a partial IRA
deduction will be available on 1999 returns to joint filers with adjusted
gross incomes of less than $61,000 and to singles with incomes under
$41,000.
In the past, a married couple above the
income-thresholds could make deductible IRA contributions only if neither
spouse was covered by a retirement plan at work.
But this restriction was eased beginning with
1998 returns. If only one spouse is covered by an employer retirement
plan, the other spouse will be eligible for at least a partial IRA
deduction so long as the couple's joint income is below $160,000.
If neither spouse is covered by an employer
retirement plan, then both spouses can make deductible contributions to a
traditional IRA, no matter how high their income.
Roth IRA Vs. Traditional IRA
The decision about which type of IRA to set up
will be a simple one for most higher-income taxpayers who will only be
eligible for Roth IRAs. But the decision is complicated if you're
eligible for both types of IRAs.
There have been numerous articles in the
financial press and advertising campaigns by financial institutions
extolling the virtues of the Roth IRA. All the ballyhoo has made the
advent of Roth IRAs seem like the financial equivalent of the Second
Coming.
And indeed, many people will find that the
ability to make tax-free withdrawals from a Roth IRA is a more valuable
tax benefit than getting an upfront deduction for contributions to a
traditional IRA.
But many people won't come out ahead with a Roth
IRA.
"I think a lot of people are going into Roth
IRA's that shouldn't be going into them," says Bob Rywick, a tax
lawyer and executive editor at the RIA Group, a publisher of legal
references for tax professionals.
Whether you're likely to come out ahead with the
upfront tax deduction from the traditional IRA or the benefit of tax-free
withdrawals from the Roth IRA depends on your tax bracket now, your
expected tax bracket in retirement, how long you plan to keep the money in
the IRA, and the return you expect from your investments.
"I think the key element is to look at what
tax bracket you're going to be in at retirement," said Mr. Rywick.
If you opt for a Roth IRA, you should expect to
be in at least as high a tax bracket – preferably a higher bracket –
when you retire than you are in now, he said.
But many workers can expect to end up in a lower
tax bracket when they retire, since most workers' incomes decline in
retirement when they are no longer earning weekly paychecks.
"If you're in a high tax bracket today and
anticipate being in a lower tax bracket when you retire, it probably
doesn't make sense to go with the Roth," said Mark Watson, a partner
in the personal financial planning practice in Washington D.C. at the
accounting firm of KPMG.
How long you expect to keep the money in the IRA
will also be an important factor.
"For somebody with a reasonably long
time period, let's say at least a 15-year time period, the best bet may be
the Roth," said Mr. Watson. "The longer you can let assets grow
tax-free, the better you're going to be with the Roth." That's why
Roth IRAs can be well suited to young-adult workers who have many decades
until retirement.
Roth IRAs are also well suited for savings
that you don't expect to need in retirement, said Mr. Rywick. The money
can be kept in the Roth IRA and passed onto heirs free of income tax. In
contrast to deductible IRAs, you aren't required to make minimum
withdrawals each year from a Roth when you reach age 70 1/2.
IRA contributions for the
2000 tax year can be
made up until April 16, 2001.
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