Tax-Free Growth and Other Advantages Provide a Powerful Savings Opportunity

As you’re no doubt aware, a variety of vehi­cles exist to help you build that nest egg for your golden years. One such vehicle is the Roth IRA. You’ve probably heard about this type of account and perhaps you even know a little bit about it. But, like many people, you may wonder whether the Roth IRA really lives up to its hype.

Well, no retirement plan is risk-free. But the Roth IRA does offer a powerful, tax-advantaged savings opportunity for those who qualify to open one. And, even if you have plenty of retirement savings, a Roth IRA can allow you to grow assets tax free to pass on to your heirs. Plus, these accounts are particularly good for supplementing savings through employer-sponsored plans.

Want to learn more? Then read on for a closer look at the benefits, eligibility requirements and other important details of this popular retirement plan.

Flexibility Makes the Difference

Senator William Roth delivered his name­sake IRA to prospective retirees as part of the Taxpayer Relief Act of 1997. It didn’t elimi­nate its counterpart — the traditional IRA — but rather offered an enticing alternative. How so? Well, to answer that question, let’s first consider what these two IRA types have in common. Both provide a tax-favored way to accumulate retirement wealth. And as long as your modified adjusted gross income (AGI) doesn’t exceed statutory limits, you can contribute a total of $3,000 ($3,500 for taxpayers over 50) annually from earned income to either or both combined. (These amounts gradually increase to $5,000 and $6,000, respectively, by 2008.)

Where these two plans diverge is in how they affect your income taxes and how much flexibility you have over contributions and distributions. You see, unlike traditional IRAs and most employer-sponsored retirement plans such as 401(k)s, Roth IRA contri­butions don’t reduce your tax-able income.

Isn’t this a bad thing? Not necessarily, because in return you receive future tax bene­fits and considerably more freedom as to how long you can contribute and when you may withdraw funds. More specifically, Roth IRAs feature the following benefits:

• Account assets grow tax free — and neither you nor your heirs will pay income tax on qualified withdrawals as long as the account is more than five years old (otherwise known as “the five-year rule”) and you’re 591/2 or older. They’re a great place to put stocks or mutual funds with high growth potential.

• These plans aren’t saddled with the required minimum distributions beginning at age 701/2 that often beleaguer traditional IRA owners as well as participants in most employer-sponsored qualified plans. In other words, you needn’t withdraw Roth IRA funds by any specific date. That means account assets can continue to grow tax free if you don’t need them. (An exception: Nonspouse benefici­aries must begin withdrawals at some point.)

• You can contribute to a Roth IRA as long as you have earned income and don’t exceed income limits. (See “Income Determines Eligibility” below.) For traditional IRAs and certain employer-sponsored plans, you can’t make contributions after age 701/2.

• Spousal beneficiaries can sometimes defer minimum distributions even further by rolling over Roth IRA assets into their own Roth IRAs.

Also, as with traditional IRAs, you may take special penalty-free Roth IRA withdrawals for death or disability, first-time home pur­chases and higher education expenses. Earn­ings withdrawals (a $10,000 maximum applies to first-time home purchases) are tax-free for the first two reasons, while earnings withdrawals for the third are not. Even better, you can take withdrawals up to the amount contributed completely free of tax and penal­ties at any time and for any reason.

Income Determines Eligibility

With these kinds of tax benefits and savings opportunities, it’s not surprising that Roth IRAs come with some eligibility require­ments. To qualify for contributing to one, you must be a joint filer with a modified AGI (before IRA contributions) of less than $160,000 or an individual with a modified AGI of less than $110,000. Eligible contri­butions begin to phase out at $150,000 for joint filers and at $95,000 for individuals.

On the bright side, these requirements are much less restrictive than those for tradi­tional IRAs, for which eligibility to make deductible contributions phases out for indi­viduals with modified AGIs between $34,000 and $44,000 and for married couples with modified AGIs between $54,000 and $64,000. (There are no AGI limits to make nondeductible traditional IRA contributions, but keep in mind that tax will still be owed on the built-up earnings or appreciation, and other traditional IRA rules will apply.)

You may ignore these traditional IRA requirements if you’re an individual not cov­ered by an employer-sponsored qualified retirement plan or if neither you nor your spouse participates in such a plan. And if only one spouse participates in an employer-sponsored plan, Roth IRA eligibility phases out between a modified AGI of $150,000 and $160,000 for the uncovered spouse and between $54,000 and $64,000 for the covered spouse.

Time Plays a Key Role

So you’ve just read about what a Roth IRA can do for you and what requirements you must meet to have one. Now you need to decide: Is this the right savings vehicle for me? A good way to answer that is to look at your age and current employment situation. The longer Roth IRA assets grow tax free, the more you’ll have to enjoy during retire­ment or perhaps pass on to your heirs. In other words, you’re best off if you have plenty of time to save and you don’t need the money you’ll be contributing to the plan. Thus, those with many years until retirement or who want to bequeath the Roth IRA assets to their heirs can especially benefit.

If this sounds like you, a Roth IRA may be able to really bulk up your nest egg. For example, by contributing the maximum $3,000 annually at the end of each year to a Roth IRA with an 8% tax-free growth rate for 20 years, you’ll have $137,286. Or, if you’re age 50 or over, and you make $3,500 “catch-up” contributions to a Roth IRA with an 8% tax-free growth rate for 10 years, you’ll have $50,703. Plus, don’t forget that maximum contribution limits will be rising by 2008 and you can continue contributions after you turn 701/2 if you are still working.

Your Estate Can Be Protected

Roth IRAs are also excellent estate planning tools, assuming you don’t expect to need the money in retirement. You can keep account assets growing for a longer time, because — unlike traditional IRAs — you needn’t make minimum withdrawals when you reach age 701/2. And you can leave heirs your IRA funds income tax free. Plus, they can take distributions from a Roth IRA over their life­times; whereas, in many instances, they can’t with a traditional IRA.

When integrating a Roth IRA into your estate plan, make sure your heirs won’t need to liq­uidate your account to pay estate taxes. If taxes will be substantial and your estate might not have the necessary liquid assets, a good way to preserve your wealth is to buy life insurance through an irrevocable trust. It will then pay the estate taxes in exchange for holding the Roth IRA funds after you die. The trustee can defer distributions for as long as practical to increase assets for beneficiar­ies who might otherwise withdraw and spend the proceeds too quickly. Use multiple trusts if significant age disparity exists among beneficiaries. Otherwise, payments in one combined trust will be based on the oldest beneficiary’s life expectancy.

Conversions Offer Advantages

Any discussion about Roth IRAs must at some point touch on conversions. That is, if you have a traditional IRA, you can convert all or a portion of it into a Roth IRA — as long as your AGI for the year doesn’t exceed $100,000 (not counting the converted IRA funds). You’ll owe income tax on previously untaxed earnings and contribu­tions, but you won’t owe the 10% early-withdrawal penalty that would otherwise apply.

In the right situation, converting your tradi­tional IRA assets to a Roth IRA allows more of your savings to grow tax free, grants you more freedom with those assets and will eventually enable your heirs to receive more of their inheritance income tax free. But a conversion isn’t always the right choice. One could push you into a higher tax bracket and disqualify you for other tax benefits.

Moreover, you probably won’t benefit from a conversion if you’ll need to withdraw IRA funds after you retire and you expect your income to then fall into a much lower tax bracket. And, as you get older, a conversion will benefit you less because the Roth IRA assets will have less time to grow enough to make up for the tax you paid on the con­verted funds.

Fortunately, you do have an “out.” If you convert a traditional IRA to a Roth IRA and your account’s value decreases during that year, you may “recharacterize” your Roth IRA back to a traditional one to avoid paying tax on the higher value. This process comes with its own requirements and risks, how­ever, so proceed with caution.

Professional Advice Is Key

As we hope this article has made clear, the savings potential, contribution and withdrawal flexibility, and tax advantages of a Roth IRA can pay off quite handsomely. But you shouldn’t consider any vehicle without professional advice. So please call us; we can help you crunch the numbers to see whether opening or converting to a Roth IRA would be the right choice for your retirement strategy.

Jeffrey Winkleman, CPA, MT, is a Principal involved with Margolis & Company’s Tax Advisory Services Group and has over twenty years experience.. Fore more information, please call Jeffrey at (610) 667-6250, or contact him at jwinkleman@marg.com.