It makes sense that federal income tax rates eventually will have to rise. Rates are at record lows and whether Congress extends the Bush-era tax cuts next year or we fall off the so-called “fiscal cliff,” the Internal Revenue Service will likely take more money than it does now out of your retirement.
One way to protect yourself against rising tax rates is to invest in a Roth individual retirement account (IRA). In a traditional IRA, contributions aren’t taxed — but withdrawals are. But with a Roth IRA, contributions are taxed — but you can withdraw from the account tax-free. With a Roth, you’ll pay an early-withdrawal penalty – but not in certain situations.
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Getting confused? It’s time to demystify the Roth IRA.
The advantage of a Roth IRA depends on whether you expect your tax rate to be higher in retirement than it is now. While that seems like a reasonable assumption, as a young investor with decades left to save, it is difficult to figure out with anything but an educated guess.
If you think your tax rate will lower in retirement (as is the case with most retirees), you are better waiting to pay that tax later in a traditional IRA. Bankrate.com has a handy Roth IRA calculator to run the numbers to see if opening an account is the right decision for you.
As an example, if you're in the 25 percent tax bracket, invest $10,000 of pre-tax dollars in a traditional IRA and it grows 6 percent annually for 30 years. At retirement, you would have more than $57,435, but have to pay $14,359 in taxes, for a net gain of $43,076. With a Roth, you would contribute $7,500 ($10,000–$2,500 in taxes) and have a net gain of $43,076.
In addition, Roth IRAs have complicated contribution and withdrawal rules to sort through:
• Contributions are limited. For 2012, you are allowed to contribute up to $5,000 a year, but kick in $1,000 more if you're 50 or older.
• You may not be eligible to contribute. For 2012, single filers earning more than $125,000 and joint filers earnings more than $183,000 cannot contribute to a Roth.
• Contributions can be withdrawn at any time, without taxes or penalties, after you reach 59½.
• There are early-penalty fees for withdrawals before 59½. You’ll pay a hefty 10 percent.
• There are no early-withdrawal penalties for some Roth investors. You can withdraw up to $10,000 in earnings to use for a qualified first-time home purchase.
Starting out, it may be better to focus on contributing to traditional retirement plans before taking the Roth plunge. If tax rates rise, you can convert your traditional IRA holdings into a Roth, but you will have to pay ordinary income taxes on the entire amount you convert. The conversion works best if you use money from outside your IRA to pay the tax. Run the numbers with the Roth conversion calculator from CalXML.
Roth IRAs have a long way to go to catch up with traditional IRAs. About 19 million U.S. households invest in Roth IRAs, which were first offered in 1998, compared with 37 million householders with traditional IRAs, according to Investment Company Institute. Since 2006, employers have offered Roth 401(k) plans. They are similar to Roth IRAs, but don't have income restrictions on who can contribute to them. Since 2006, employers have offered Roth 401(k) plans. They are similar to Roth IRAs, but don't have income restrictions on who can contribute to them.
You can find plenty of tools online to figure out if the Roth is a good choice for you. Moneychimp offers a calculator comparing a Roth vs. a traditional IRA to help you decide.