The Taxpayer Relief Act of 1997 provides several inducements for retirement savings. The Act creates education individual retirement accounts (IRAs). It offers the ability to withdraw funds from IRAs without penalty for higher education expenses, as well as the limited ability to withdraw funds for a first-time home purchase. It expands eligibility for the deductible IRA. It eliminates the excise tax on excess IRA and qualified retirement plan distributions and accumulations. But perhaps the greatest benefit the Act offers is the new savings vehicle called the Roth IRA.

How the Roth IRA Works

Starting in 1998, a husband and wife with an adjusted gross income (AGI) of up to $150,000 (and singles with AGI up to $95,000) can each make annual contributions of $2,000 to a Roth IRA. Unlike those made to traditional IRAs, the contributions are not deductible, but they do still grow tax-deferred. And, qualified distributions from both contributions and their earnings are tax-free. By contrast, deductible contributions and their earnings are both taxed on withdrawal from a traditional IRA.

Another way to establish a Roth IRA is through a rollover from an existing IRA. At the time of the rollover, you will owe income tax on all previously untaxed contributions and earnings, but you won’t be subject to the 10% early withdrawal penalty. And, if you roll over IRA assets before Jan. 1, 1999, the resulting tax bill will be spread over four years. If your AGI for the year (not including the amount rolled over) exceeds $100,000, you cannot roll over the IRA during that year.

Should You Pay Tax Now?

The Roth IRA promises greater long-term benefits than the deductible IRA. Why? As a general rule, as long as your income tax rate stays the same or increases at the time you withdraw funds, you will end up with more money in a Roth IRA than in a deductible IRA because the growth is never taxed. If, however, you expect your rate to be lower at retirement, you are probably better off with the deductible IRA.

Look at the example above. Assume you contribute $2,000 per year for 5, 10, 15 or 20 years, you earn a compound annual return of 8%, and you then withdraw the proceeds without penalty. For the deductible IRA, assume you were in the 28% income tax bracket when the contributions were made. As you can see, as long as your income tax rate doesn’t drop, you will have more funds available for your use with a Roth IRA.

Should You Roll Over?

To decide if a rollover makes sense, determine whether the benefit of not paying tax when you take distributions will likely outweigh the cost of the immediate income tax on the amount rolled over (which will leave less in the account to grow tax-free). In other words, when you take distributions will you have more available for your use in a Roth IRA than you would have in a deductible IRA?

Let’s look at an example. Laura has an IRA that holds deductible contributions and their earnings. In January 1998, she considers withdrawing $10,000 from her IRA and rolling it into a Roth IRA. She has $2,800 in a taxable account which she can use to pay the tax that will result from the rollover, and she expects her AGI for 1998 to be $55,000.

Assuming that the IRA will grow at 10% annually, that Laura will remain in the 28% bracket and that the taxable account will grow at a 7.2% after-tax basis, should she make the rollover? Let’s compare the possible outcomes of her two options:

1. If Laura leaves $10,000 in her deductible IRA, in 20 years she will have $67,275 in her IRA, but only $48,438 available for her use because of the 28% income tax on her withdrawal. She will have $11,247 left in her taxable account ($2,800 plus growth), for total funds of $59,685.
2. If Laura rolls $10,000 into a Roth IRA, in 20 years she will have $67,275 in her IRA which will all be available for her use because the withdrawal will be tax-free. She will have only $1,083 in her taxable account, because of the taxes of $700 per year for four years that she paid on the rollover. Her total funds available will be $68,358.

This example indicates that the Roth IRA will provide a better result for Laura. It does assume, however, that she will live for 20 more years, and, perhaps more important, that the law will not change again!

4 Key Questions

Your answers to the following four key questions will help you determine whether a Roth IRA is a better option for your situation than a deductible IRA:

1. When will you take distributions? If you still have a long time until you will retire or take other qualified distributions, a Roth IRA may be beneficial because you will accumulate a large amount of earnings that you won’t have to pay taxes on. If you have a shorter time until retirement but don’t expect to take distributions then, a Roth IRA will probably still be good for you because you can continue to let the amounts in the IRA build up tax-free indefinitely and can continue to make contributions, even after age 70 1/2.
2. Will you be in the same, a higher or a lower tax bracket when you take distributions? If you will be in at least as high a tax bracket when you need to take distributions from the IRA as you are in now, a Roth IRA may be beneficial because you likely will not pay any more in taxes by paying them up front.

   If you are considering rolling over funds from a traditional IRA, also consider the following questions:

3. How long has your traditional IRA been open? If it has been open for a relatively short period of time and your answers to the previous questions also incline you toward the Roth IRA, a rollover will likely be beneficial because you won’t have much earnings to pay taxes on at the rollover and the potential for tax savings on future earnings is great.
4. Does your traditional IRA consist primarily of deductible or nondeductible contributions? If it consists primarily of nondeductible contributions and your answers to the previous questions indicate that a Roth IRA will likely be beneficial, a rollover is the best option because you will have to pay tax only on the limited deductible contributions and any earnings, and the potential for tax savings on future earnings is great.

Each situation is different and must be analyzed based on your set of circumstances. We would be pleased to assist you in determining if the Roth IRA is right for you. 

What Is a Qualified Distribution?

Qualified distributions from Roth IRAs are not subject to income tax or the 10% early withdrawal penalty. Distributions are qualified if:

• The account has been open for more than five years, and
• Distributions are made after age 59 1/2 or as a result of long-term unemployment, disability or death, or are used to buy a first home.

Other Roth IRA Benefits:

• Although nonqualified distributions coming from earnings in the IRA are taxed, distributions are treated as coming first from contributions, which are not taxable.
• No minimum distribution rules.
• Post-age-70 1/2 contributions allowed.