The Roth Individual Retirement Account
The Roth IRA, available since 1998, presents a potentially attractive alternative to the regular IRA long favored by many Americans as a cornerstone in their retirement planning efforts. That’s because a Roth IRA may allow you to avoid future taxation of your retirement funds by making nondeductible contributions now.
Rules of the Roth IRA
Following is a summary of the rules for Roth IRAs:
Unlike the traditional IRA, contributions to a Roth IRA are nondeductible regardless of your income level or participation in a company-sponsored retirement plan.
Your contributions are limited to $4,000 a year ($8,000 for couples) in 2006. The contribution limit begins to decline or “phase out” for single taxpayers with adjusted gross incomes (AGIs) of more than $95,000 and for married couples filing jointly with AGIs of more than $150,000. Individuals with AGIs in excess of $110,000 ($160,000 for married couples filing jointly) are not eligible for a Roth IRA. Married taxpayers filing separately are not allowed to contribute to a Roth IRA. An individual’s total contributions to all IRAs, traditional and Roth, may not exceed the annual contribution limit ($4,000 in 2006).
Contribution limits will increase in the years ahead. The annual contribution limit for a Roth IRA is $4,000 in 2006. It will increase to $5,000 in 2008. Then, the annual contribution limit will be adjusted for inflation. Older Americans are also able to make so-called “catch-up” contributions to a Roth IRA. The allowable catch-up contribution is $1,000 per year but is not adjusted for inflation.
Your contributions to a Roth IRA may continue beyond age 70 1/2. You are not required to start taking distributions from a Roth IRA at age 70 1/2, as you are with a traditional IRA, and you can continue to contribute as long as you have earned income. When a Roth IRA owner dies, however, his or her heirs must adhere to the same minimum-distribution rules that apply to regular IRAs.
The taxable portion of a nonqualified distribution is subject to a 10% tax penalty. If you make withdrawals that do not meet the rules for a qualified distribution, you’ll owe taxes on all or a portion of the withdrawal. You must also pay a 10% penalty tax on the taxable portion of the withdrawal.
Retirement plan “rollovers” are permitted, but only from Roth-style plans. If you are changing jobs or retiring, you can roll over funds from an employer retirement plan such as a 401(k) account directly to a Roth IRA, but only if it is a Roth-style plan. Beginning in 2008, however, direct rollovers from a non-Roth plan will be allowed. The rollover will be treated as a conversion, with income taxes due on all proceeds.
The Traditional IRA vs. the Roth IRA
When deciding whether a regular IRA or a Roth IRA is best for you, you’ll want to compare the after-tax dollars that would be available to you under each option. This will depend on many factors, including your tax bracket, how many years you have until retirement, and when you wish to begin making withdrawals. For many people, a Roth IRA will result in more after-tax income during retirement because qualified withdrawals from a Roth IRA are tax free, while withdrawals from a regular IRA will be taxed.
For those whose contributions to a regular IRA are tax deductible and who are in a higher tax bracket today than they will be in during retirement, a regular IRA may be the smart choice.
If you are not eligible to participate in a company-sponsored retirement plan, you can make deductible contributions to a regular IRA regardless of your income level, up to $4,000 in 2006. Deductible contributions may be reduced or eliminated for individuals who participate in a company-sponsored retirement plan, based on their incomes.
Conversion of a Regular IRA to a Roth IRA
In creating the Roth IRA, Congress included provisions for converting a regular IRA to a Roth IRA. You must have an AGI of $100,000 or less to qualify for a conversion to a Roth IRA (this limit is scheduled to be eliminated in 2010). Since the investment earnings and capital gains in your regular IRA have not been taxed yet, the government will take its share at the time of the conversion. If you have a nondeductible, regular IRA, its earnings will be taxed but the amount of your contributions will not. The withdrawal from your regular IRA will count as income but will not affect your eligibility for a Roth IRA (or the $100,000 income limit) or trigger the 10% penalty usually imposed on early withdrawals.
Which Is Right for You?
If you have a regular IRA and are considering converting to a Roth IRA, here are a few factors to consider:
- A Roth IRA may be more attractive the further you are from retirement. Why? Because the longer your earnings can grow, the more income you may have that is never taxed. On the other hand, if you convert to a Roth IRA close to retirement, your investments may not have much time to compensate for the associated tax bill.
- If your regular IRA contributions are nondeductible, you may be better off with a Roth IRA. That’s because the distributions of earnings from your regular, nondeductible IRA will eventually be taxed. The qualified distributions from a Roth IRA will not.
- Your current and future tax brackets will affect which IRA is best for you. For example, if you are currently in a high tax bracket and expect to be in a much lower tax bracket during retirement, a regular IRA could be the best option. Why? Because you may be able to claim a deduction on your contributions now and then pay taxes on future distributions at the lower rate later. Keep in mind that some experts say you could still come out ahead with a Roth IRA if you can fund it for at least 12 or 15 years before retirement.
SUMMARY
- Roth IRA contributions are nondeductible, but qualified withdrawals are tax free.
- Individual contributions to all IRAs are limited to $4,000 in 2006. Note that this amount will increase in the years ahead.
- You may continue contributions to a Roth IRA after age 70 1/2, and there are no mandatory withdrawals.
- You can make penalty-free withdrawals from a Roth IRA before age 59 1/2 for a first-time home purchase or if you die or become permanently disabled.
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As more workers enter retirement relying on cash from a 401(k) plan or similar account instead of a company pension, fears are growing that some could mismanage their money and outlive their savings.
To reduce that risk, the Obama administration wants to prod workers into investing in lifetime-income products such as annuities, insurance contracts that function like pensions by paying a guaranteed monthly income in return for a big chunk of cash upfront.
This year, the Labor and Treasury departments asked for comments on steps the government could take to steer workers into annuities. One suggestion would require that part of an employee’s 401(k) plan contributions be placed in an annuity that would automatically start providing income at retirement, unless the worker opts out.
Treasury and Labor plan to hold a hearing on the proposals beginning Sept. 14. Among the topics to be discussed, according to the hearing announcement, are the concerns expressed by some about the choice of annuities over other investments and strategies that also aim to provide lifetime income. Individuals who submitted comments during the public-comment period overwhelmingly rejected the idea of mandatory annuities, and few retirees choose to buy annuities when they cash out their defined-contribution plans.
Still, many financial pros say annuities and related products can help reduce the risk you’ll outlive your savings. For people interested in securing an income stream for life, here’s a look at some available offerings:
Immediate Annuities
With an immediate fixed annuity, you make a lump-sum payment to an insurer that promises to pay you a specified sum each month, or at other regular intervals, for as long as you live.
For example, a 66-year-old man who invests $50,000 in an immediate fixed annuity could get monthly income for life of about $324, according to annuity shopping site Immediateannuities.com. Adding a 64-year-old spouse to the contract, with payments continuing until the death of the second person, would cut the monthly check to $253.
One approach is to lock in enough annuity income to cover the gap between your Social Security check (and any pensions) and your minimum income needs. Very conservative investors may decide to annuitize a larger share of their savings, but financial advisers generally say investors shouldn’t put all of their money into an annuity.
Consumers often worry that if they die young, they will have thrown their retirement savings away buying annuities. In the case of the couple above, adding a guarantee that payments will continue for at least 20 years—with the money going to beneficiaries if both spouses die—would bring the payment down to $247, according to Immediateannuities.com.
One drawback of most immediate annuities is that rising consumer prices over time will erode the purchasing power of the fixed monthly payment. Some insurers offer inflation-indexed annuities, but the trade-off is that the initial payment is considerably smaller than on a conventional immediate annuity.
The appeal of annuities depends in part on your health and your desire to leave a financial legacy, experts say. Those in poor health, or who want to leave the largest possible inheritance, might decide not to put a big amount into an annuity.
Investors should check the A.M. Best Co. rating of the insurer and choose one with a strong rating. Investors also should check the limits of their state’s guarantee fund, which helps pay claims of insurers that become insolvent. While coverage limits vary by state, most guarantee an individual at least $100,000 in annuity benefits per insurer, which is why some investors diversify annuity purchases among insurers.
In the current environment of low interest rates, investors may want to spread annuity purchases over several years, says David Macchia, founder of Wealth2k Inc., which develops annuity “laddering” strategies. That way, you can lock in higher payments on annuities purchased in years when interest rates are higher, he says.
Longevity Insurance
If you decide against an immediate annuity and choose instead to take systematic withdrawals from your retirement savings, you may want to consider longevity insurance, another type of annuity offered by some insurers.
Longevity insurance is generally purchased before or at retirement and guarantees an income that begins paying at a set age, usually 75 and up. Some advisers suggest pairing longevity insurance with another type of investment or withdrawal plan designed to last until the longevity checks start arriving. Longevity insurance also can be used to boost income in later retirement, when many people need more income for health care or assisted-living costs.
A 65-year old man who invests $50,000 in a longevity annuity offered by MetLife Inc. will get an estimated $1,000 a month if he begins taking income at 75, or $1,580 if he waits until 80. The younger you are when you buy the policy, the larger the payments will be, partly because of the increased time for investing. A 60-year-old investing the same amount would get about $1,300 monthly at age 75, or about $2,040 at 80, according to MetLife’s figures.
As with immediate annuities, the monthly payment is reduced if you include a second person or add a guaranteed payment period. If the investor dies before his target age, some policies, including the one from MetLife, will return the original investment along with interest.
Managed-Payout Funds
Mutual-fund companies, seeking to hold on to customer assets that might otherwise flow to annuities, in recent years have rolled out mutual funds designed to provide monthly income to investors such as retirees.
But income from these so-called managed-payout funds isn’t guaranteed. And with these funds debuting in a hostile stock-market environment, early investors have seen their monthly payments shrink.
One type of payout fund generates monthly payments with the goal of liquidating its assets by a target date—usually 10, 20, or 30 years later. A second type is based on the idea of a college endowment. It aims to produce regular payments, while preserving at least some of the original investment. Vanguard Group Inc., Fidelity Investments and Charles Schwab Corp. are among the firms that have launched managed-payout funds.
So far, the funds have highlighted the trade-off that comes with an investment linked to the market. The payouts on Vanguard’s three managed-payout funds, for example, have fallen about 25% since their launch in May 2008. A Vanguard spokeswoman said the funds are intended to meet their objectives over long periods.
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When Congress returns in September, it will have four months to do what it has failed to do in the past nine years: fix the absurd situation it created for the estate tax.
As part of the 2001 tax cuts, Congress gradually reduced the tax rates and increased the exemption for the estate tax, which is levied on a person’s assets after death. These changes, which were limited to 10 years, repealed the estate tax this year, only to allow it come back next year at 2001’s high rates and low exemptions.
Everyone knew this scenario made no sense, but Republicans and advocates for family-owned businesses were confident they eventually could win a permanent repeal of the estate tax. Those hopes disappeared when Democrats took over Congress in 2007, and efforts to reach a compromise so far have failed.
If Congress doesn’t address the issue by the end of the year, estates valued at $1 million or more would be subject to the estate tax. (For couples, the exemption could be doubled to $2 million.) The top estate tax rate would climb to 55 percent. That’s up from zero this year. In 2009, it was 45 percent with a $3.5 million exemption.
“There’s no way that’s going to happen,” said Clint Stretch, managing principal of tax policy for Deloitte Tax LLP in Washington.
If it does happen, many more Americans — including families who own businesses — would be hit by the estate tax, or at least the costs involved in avoiding or reducing its bite.
Stretch thinks the estate tax will be resolved when Congress decides what to do about individual income tax rates for high earners. Reducing the rates and increasing the exemption for the estate tax could be combined with an income tax increase for wealthy Americans and an extension of current tax rates for the middle class.
Or, if Congress decides to extend lower rates for high earners for another year, it could pass a one-year fix in the estate tax as well, then deal with the issue again next year.
Democrats have proposed reviving the estate tax at 2009’s levels, while Republicans have proposed more favorable terms for estates: a $5 million exemption and a 35 percent tax rate.
The Family Business Estate Tax Coalition, a group of 51 business groups ranging from the American Farm Bureau Federation to the U.S. Chamber of Commerce, endorsed the Republican alternative.
“The higher exemption level and reduced rate will lessen the burden of the estate tax and provide family businesses and farms with more capital to create much-needed jobs and invest in their business,” the coalition stated in a letter to senators.
The trickiest decision facing Congress will be whether to impose the tax retroactively on the estates of individuals who died this year. Lawsuits will be filed challenging whether Congress has the authority to tax an event that already has occurred.
“Anything they do is going to be a mess,” Stretch said.
One possible compromise would allow this year’s heirs to choose between paying an estate tax, or paying capital gains taxes on the difference between what the decedent originally paid for the assets and the sales price the heirs receive for the assets.
Making the estate tax optional, however, could create tension between executors and heirs, Stretch said. He doubts this scenario was addressed in any wills.
“Nobody drafted that,” he said.
“The policy answer was for Congress to do its job last year, but it didn’t,” he said.
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