By Lisa Coffey
Ah, the grapes of Roth -- the Roth Individual Retirement Account, that is. Will the fruit of this vine prove sweet or sour to investors?
Named for its sponsor, U.S. Sen. William Roth, R-Del., the Roth IRA operates much like a conventional IRA in that it can be invested in stocks, bonds, mutual funds and other similar money-yielding vehicles.
But the key difference is that in a conventional IRA, the interest earned is tax-deferred, with the tax rate likely to be lower whenever one starts withdrawing from one’s IRA during the relatively income-lean years of retirement. Additionally, for most people, the dollar amount they deposit each year in their conventional IRAs is tax-deferred, meaning the contribution is deducted from one’s taxable income. For those who contribute the maximum $2,000 per year to their conventional IRAs, that means about $700 less in federal and state taxes paid for that tax year.
In the Roth IRA ($2,000 maximum contribution allowed annually per individual, $4,000 for couples), there is no upfront tax deduction; the money one opts to deposit already has been taxed. But any interest earned on the Roth IRA is untaxed. Distributions taken from a Roth IRA will remain tax-free if the following two circumstances are met:
1) The IRA owner is age 59-1/2 or older at withdrawal, dies, becomes disabled or uses the distribution to fund up to $10,000 toward the purchase of a first home; and
2) The account has been established for more than five tax years.
If these two conditions are not met, any proceeds from the Roth IRA will be treated as a return of previously taxed earnings, with special rules applying.
Regarding withdrawal of principal contributed (not interest earnings), an individual may withdraw such funds tax-free anytime.
The Roth IRA is available to anyone whose adjusted gross income is less than $110,000 annually (less than $160,000 for couples filing jointly).
Several factors will help determine which IRA to choose: the expected rate of return on funds; how long the funds will remained untouched before withdrawal; the investor’s specific tax brackets during not only his or her years of contribution, but the time of funds withdrawal; inflation; changes in domestic and international politics; changes in personal circumstances; and future changes in the tax code, for example.
What’s helpful, if folks happen to have a spreadsheet program handy, is to calculate a few scenarios relative to their own situations.
For example, take an investor who’s 49-1/2 years old, working and wants to contribute to a Roth IRA during the next 10 years -- until he retires at 59-1/2. Say the Roth IRA earns 8 percent per annum, compounded annually. If he contributes the maximum $2,000 each year, he’ll end up with $31,290 in principal and earned interest by the time he’s 59-1/2 and be able to withdraw the full amount without taxation, having already had his contributions taxed.
Conversely, the conventional IRA, also earning 8 percent per annum in our scenario, also yielded principal and interest totaling $31,290; however, after paying deferred federal and state income taxes of, say, 25 percent total, our investor would depart with only $23,468. But wait. Add to that figure the $7,000 saved over the past 10 years in federal and state taxes (remember, he paid about $700 less per year in taxes because his conventional IRA contributions reduced each year’s taxable income and thus the tax paid). Now the two yields for these two different IRAs look comparable: $31,290 for the Roth IRA vs. $30,468 for the conventional IRA. Had the fellow invested that accumulating $7,000 over the last 10 years, the conventional IRA likely would come out ahead here.
Or would it? One key factor is the tax bracket in which the 59-1/2-year-old investor will find himself when cashing out his IRA. Will he be receiving pension money that year or other taxable retirement income?
Clearly, a multitude of factors determines the “better” IRA. In general, however, the higher the investment rate and the longer the money ferments in the account, the headier the end-term Roth proceeds and the greater the gap between the Roth’s and the conventional IRA’s net earnings. It’s not having to pay taxes on a healthy interest yield -- juicy interest earnings that well exceed your principal contributions, for example -- at the end of the game that makes the Roth IRA so attractive in such a case.
T. Rowe Price, an investment firm, offers a free information packet called “The IRA Investing Kit for 1998.” Call the company at 1-800-333-0740 to request one. Or check out Prudential’s IRA web site for some good information on retirement planning in general and IRAs in particular at the following address: www.prudential.com/retirement/ira/.
Don’t forget that the Internal Revenue Service, particularly after its recent lashing by Congress, is striving to be a kinder, gentler tax collector. Visit www.irs.gov/tax_regs/ for excellent updates on recent and proposed tax regulations that may impact your investment strategies.
In most cases, any reputable company investment plan that fully matches a percentage of one’s 401(k) or savings contributions is the best bet. It’s hard to beat a 100 percent return on investment, even if some of that return is taxed. But when it comes to IRAs, don’t be sold on the pros or cons of any one type in all scenarios. Each investor’s case is different, not to mention that ever-changing swirl of variables called reality, with its notorious habit of confounding the best-laid plans of mice, men and investors.
Aside from that caveat, good money stewards who study the fiscal seasons, keep their eye on the vineyard, learn as much as possible about what’s needed for a ripe harvest and pray for a good year will be well ahead of their not-so-conscientious peers.
Regardless of the investment vehicle, put aside money for those wine-and-roses retirement years in the first place -- the sooner, the better.
Coffey, who holds MBA and business degrees from Indiana Wesleyan University, is an editorial writer and columnist for The Indianapolis News. She may be reached at COFFEY9999@aol.com.
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