Since the creation of Roth IRAs in 1998, more than 14 million U.S. households have opened a Roth to take advantage of the opportunity for tax-free earnings on their retirement assets, according to the Investment Company Institute.
Before you rush out for a Roth IRA application, consider the implications of opening a Roth or converting your traditional IRA to a Roth IRA.
Timing and Taxes
Determining whether a Roth IRA is appropriate for you may be a matter of timing and tax brackets. Traditional IRAs may offer tax deductions on initial contributions, whereas Roth IRAs offer tax breaks when you take withdrawals. To qualify for the tax-free and penalty-free withdrawal of earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59½ or due to death, disability, or a first-time home purchase ($10,000 lifetime maximum). Depending on state law, Roth IRA distributions might be subject to state taxes.
If you believe you will be in a lower tax bracket when you retire, it may make sense to contribute to a traditional IRA and take the tax deduction now while you are in a higher bracket. The reverse also holds true. If you expect to be in a higher tax bracket when you retire, contributing to a Roth IRA may be a better option. Eligibility to contribute to a Roth IRA phases out at higher modified adjusted gross income levels.
When you reach age 70½, you must begin taking required minimum distributions from a traditional IRA. There are no such distribution requirements for a Roth, which means your funds can continue to accumulate untaxed for a longer period, if you desire.
Roll to Roth?
If you think your tax rate will be higher when you are ready to withdraw your money in retirement, it may make sense to convert a traditional IRA to a Roth and pay the taxes now. To qualify for a conversion, your adjusted gross income cannot exceed $100,000. Keep in mind that you must pay federal income taxes on assets converted to a Roth IRA. And if you use money from within the original account to pay those taxes and you are under age 59½, you will be subject to an additional 10 percent federal income tax penalty.
Traditional and Roth IRAs can play an important role in your portfolio.