Individual Retirement Accounts (IRAs)
The Roth IRA offers taxpayers a third option in addition to the deductible and nondeductible IRAs. Many taxpayers will need to decide whether to convert their current IRA accounts to Roth and what type to contribute to for 2006.
Contributions to a Roth IRA are nondeductible and distributions are tax-free after age 59.5 if the account is at least five years old. The taxpayer can continue to contribute to a Roth after age 70.5. A qualified Roth distribution is tax-free and not subject to a 10% premature withdrawal penalty if the account has been in existence for five years, is made after age 59.5 or made on account of the taxpayer's death or disability. First-time homebuyers also can take a tax-free qualified distribution from the Roth IRA without penalty after the five-year period under certain circumstances.
A first time homebuyer is one who had no ownership interest in a principal residence during the two-year period ending on the date the new residence is to be acquired. There is a lifetime limit of $10,000 on the distribution, which must be used to pay usual and reasonable settlement, financing and closing costs within 120 days of the distribution.
A Roth must be designated as such by the taxpayer at the time it is established. The total annual contributions to all three types of IRAs cannot exceed $4000 - $5000 for taxpayers age 50 or older. For higher income individuals, the allowable contributions is phased-out pro rata, for single taxpayers with adjusted gross incomes (AGI) of $95,000 to $110,000 and $150,000 to $160,000 for married filing jointly. Taxpayers filing separately cannot make contributions, regardless of income.
Active participants in a qualified plan (401K) can contribute to non-deductible IRAs without regard to AGI and taxpayers that are not active participants can contribute to deductible IRAs with no AGI limits.
Married taxpayers with combined AGI of more than $160,000 are not eligible for the Roth IRA, however, if neither spouse participates in a qualified plan, both are eligible for a deductible IRA. For married taxpayers with AGI less than $160,000 and neither spouse contributes to an employer-sponsored plan, both taxpayers are eligible to contribute to either a Roth or deductible IRA. When one spouse contributes to an employer plan and AGI is $54,000 to $160,000, the nonparticipant spouse is eligible for a Roth or deductible IRA. For married couples with an AGI under $85,000, both spouses qualify for a Roth or deductible IRA.
Deductible IRA or Roth?
The deductible IRA is a better alternative only if the taxpayer's marginal tax rate is higher now than it will be in retirement and only if the tax savings are invested each year. The marginal tax rate is the amount of taxes applied to each dollar of additional income. If the number of years before the taxpayer begins distributions is small (five or fewer), the advantage of either IRA will be small. The calculations for determining which IRA is best for you can be complicated and should be figured by a personal financial advisor or the company that currently handles your IRA (i.e. Charles Schwab, Fidelity). They should be using a complex IRA calculator and not a simplistic one, such as the ones available for use on the Internet. The advisor helping you with these calculations should ask many questions and should cause you to dig into your files to find the answers.
There are advantages and disadvantages in converting a regular IRA to a Roth and again there are important factors such as marginal tax rates and years of contributions remaining that go into these calculations. Also to be considered before rolling over, is the effect the extra income will have on being able to take the new child credit, education credits, interest expense deductions for student loans, medical expenses and the miscellaneous itemized deductions. All of which are subject to some phase out at certain income levels.
To be eligible to convert an existing IRA to a Roth a taxpayer's adjusted gross income can be no more than $100,000 (not including the taxable rollover amount) whether filing single or joint. Married filing separate taxpayers will not be allowed the conversion. The critical issue is whether a person wants to pay taxes now, during the earned income years versus later, during retirement. Again, a financial advisor who is knowledgeable and has the complex calculator to determine the proper course of action should complete the calculations.