This is a good time to take a new look at your IRA and 401(k) strategies and see how they may affect your taxes. Because of a variety of new federal laws and new lawmakers in Congress, Roth IRAs have become even more attractive... newly introduced Roth 401(k) plans have emerged as a tempting alternative to traditional 401(k) plans... and the idea of converting from a traditional IRA to a Roth IRA is becoming more appealing. Here, an update on the best strategies...
Roth IRAs Gain Appeal
Investors are usually better off contributing as much as possible to a Roth IRA rather than a conventional one. With a conventional IRA, you can deduct contributions from income taxes, provided that you have no other retirement plan, such as a 401(k) -- but you eventually must pay taxes on IRA withdrawals.
In contrast, you cannot deduct contributions to a Roth, but you pay no taxes on withdrawals of any Roth money after age 59½, as long you have held the account for at least five years. And unlike owners of conventional IRAs, Roth IRA owners are not required to start withdrawing money at age 70½. That usually means more money for you in the long run. No matter how much your account grows, you won't face a tax bite in the end.
Despite the benefits, some accountants have steered clients away from Roths. They worried that tax rates would drop in the future -- especially with a Republican Congress -- or that a client's tax rate would drop in retirement if the retiree earns less income then. That might mean the Roth advantages shrink or even disappear.
The thinking now, however, is that with the advent of a Democratic Congress, big tax cuts are less likely -- making the Roth IRA an even better bet.
Deadlines: You have until April 17, 2007, to make a Roth contribution for tax year 2006 and until April 15, 2008, to make a contribution for 2007.
If you are age 50 or older, you may contribute up to a total of $5,000 in the two forms of IRA... for people under age 50, the limit is $4,000.
The Roth IRA is not open to new investments for married couples filing jointly with modified adjusted gross incomes (AGIs) of more than $160,000 and singles with more than $110,000 for 2006. For 2007, the limit is $166,000 for couples and $114,000 for singles.
A New Twist on the 401(k)
The law allowing employers to offer Roth 401(k) plans beginning in 2006 was due to expire after 2010. But last summer, Congress made that alternative to the traditional 401(k) permanent, prompting more employers to consider the option. If your employer offers a choice of a Roth or a traditional 401(k), favor the Roth in most cases.
Exception: If you're in the 33% or 35% tax bracket now and expect to drop to the 15% bracket in retirement, favor the traditional 401(k) over the Roth 401(k).
Like a Roth IRA, the Roth 401(k) does not allow tax deductions on your contributions, but it allows you to escape taxes on withdrawals. People who are age 50 or older by year-end can contribute up to $20,500 into a Roth 401(k) this year, up from $20,000 last year -- the same limits as for conventional 401(k)s. For people under age 50, the limit for 2007 is $15,500. There is no limit on how much income you can earn to contribute to a 401(k) -- Roth or traditional.
In gauging how much to put in the Roth versus the traditional 401(k), keep in mind that any matching contributions from employers go into the traditional 401(k), not the Roth.
Consider Converting
If you have a conventional IRA, consider converting it to a Roth. Currently, only people with modified AGIs of $100,000 or less can convert, but thanks to a change in the law, starting in 2010, anyone will be able to do so.
Meanwhile, if you exceed the income cap for contributing to a Roth IRA, you could load up on contributions to a conventional IRA in anticipation of converting in a few years.
Beware: Conversions produce immediate tax bills and may even kick you into a higher tax bracket if you convert too much in a single year. Say a married couple filing jointly has taxable income of $75,000 in 2007. If they convert more than $53,500, that may increase their total taxable income to $128,500, which bumps them from the 25% bracket to 28% for any income above that level. But even so, the eventual benefits will likely exceed the drawbacks.
The best years to convert may be after you retire, when wages halt and your tax bracket drops, but before age 70½, when required minimum distributions kick in on a traditional IRA.
Charitable Bequests
If you plan to donate an IRA to a charity after your death, invest enough in the traditional IRA and 401(k) to fund the bequest while getting immediate tax breaks, rather than contributing or shifting those assets to Roth IRAs. Neither your estate nor the charity pays taxes on the distribution. (In 2006 and 2007 only, you can roll over up to $100,000 of an IRA to a charity without paying taxes while you are alive, as long as you are age 70½ or older.)
Delay IRA Withdrawals
When you reach retirement, follow a strategy to minimize taxes on withdrawals. Say you retire at 65 with money in a taxable account, as well as Roth and conventional IRAs. Start by taking money out of the taxable account. That way you preserve assets in the tax-sheltered IRAs as long as possible. Be aware that even though you don’t pay taxes on Roth withdrawals, if you shift the money to unsheltered investments, you may begin paying tax on the new interest, dividends and capital gains.
When selling taxable investments, sell losers first. By doing so, you can book a capital loss to offset taxable gains from other investments.
After age 70½, you must start taking required minimum distributions from the conventional IRA. To stretch out the shelter's life, withdraw the least amount of money that the IRS requires. In general, make withdrawals from the Roth IRA only after the other sources have been exhausted, because that provides the best tax shelter.
With a Roth, you don't have to make withdrawals -- just leave the money sheltered and pass it on to heirs if you have other resources. Also, you can avoid taking required minimum distributions from a Roth 401(k) by rolling that into a Roth IRA after you retire or switch employers. Your heirs who inherit the Roth must eventually take required minimum distributions, but they also don’t pay taxes.
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Bottom Line/Personal interviewed James Lange, CPA and attorney in Pittsburgh, with 27 years of experience in devising strategies for IRAs and other retirement plans. He is author of Retire Secure! Pay Taxes Later: The Key to Making Your Money Last As Long As You Do (Wiley).
website: www.BottomLineSecrets.com
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