New Math for IRA Savings

Usually, the last thing anyone giving financial advice needs to do is to tell Americans to dodge taxes. Tax our tea unfairly and we’ll start a revolution. Give us a holiday from sales tax and we’ll buy all kinds of clothes and appliances we don’t need. Launch single-state muni-bond funds whose yields are exempt from income taxes in jurisdictions that don’t even have income taxes and we’ll plow our money into them.

If all the other rules governing traditional IRAs and Roth IRAs were identical, there would be no reason to favor a Roth. Algebra says it shouldn’t matter whether taxes are applied to contributions or a compounded total. But there are three big reasons why a Roth can be better.

First, since creating Roth IRAs in 1997, Congress has never distinguished between the limits on making contributions to them and on making deductible contributions to traditional IRAs. In 2009, for instance, you can put a total of $5,000 into IRAs of both kinds ($6,000 if you’re 50 or older). And that equivalence means Roth IRAs give you more bang for your buck. To take a simple example, let’s say you put $5,000 into a Roth IRA this year and leave it untouched for 30 years. If it grows at 6 percent a year, you would end up with $28,717, tax free. To get that much from a traditional IRA in 30 years at 6 percent, you would have to invest $6,944 initially, let it grow and then pay income tax on the total (assuming you’re in the 28 percent federal bracket). But you can’t—you can invest only up to $5,000.

Now, with a traditional IRA, you do get an up-front deduction. In this case, that would be worth $1,400. But even if you invest your deduction in a taxable account for 30 years, the total will still fall short of the Roth IRA’s. It may seem paradoxical that after-tax dollars make for a better tax shield, but the combination of equal contribution limits and tax-free withdrawals gives the Roth an edge.

The second advantage to a Roth is easier to understand: no mandatory distributions. In contrast, you face stiff penalties if you don’t start drawing down a traditional IRA by age 70½.

Third, since you can accumulate large sums in Roth IRAs without having to worry about taking distributions, they make excellent vehicles for estate planning. You can pass a Roth IRA to your heirs and they will never have to pay taxes on the amounts they withdraw. They will have to make mandatory distributions according to IRS timetables but can stretch out drawdowns over their lifetimes, which makes Roth IRAs a particularly good asset to leave to grandchildren.

If this all sounds too good to be true, well, I actually don’t have a nasty surprise up my sleeve. Roth IRAs are terrific. And so are their workplace cousins, Roth 401(k)s. Roth vehicles should be significant components of retirement planning for anyone who’s eligible. (Individuals earning more than $120,000 and couples earning more than $176,000 in 2009 can’t contribute to a Roth, though contributions start getting phased out at $105,000 and $166,000, respectively.)

So why aren’t they? The very nature of Roth tax breaks is one important reason. For decades planners (and financial magazines) preaching the importance of making regular retirement investments have stressed the benefits of deductible contributions to IRAs and pretax contributions to 401(k)s. Then Roth IRAs came along, and suddenly, investors were supposed to ignore those up-front gains to get extra gratification later. That’s a serious adjustment to make—and it’s complicated by the often complex rules for investing in various types of accounts.

There’s also a legitimate tax-bracket concern about Roth IRAs. With traditional IRAs, you defer taxes until you cash out your savings, which is particularly damaging if you move into higher tax brackets over the course of your lifetime. But the opposite holds for a Roth, where you pay your taxes early: If you move into a lower tax bracket after retiring, the benefits of tax-free growth won’t be worth as much. So if you think there’s a chance you’ll have significantly lower annual income in retirement, it makes sense to diversify among traditional and Roth IRAs, to gain some tax advantage either way.

Finally, there had been serious legal limits on converting traditional investments to Roth IRAs, but these have been falling away—and here’s where we get back to why Roth IRAs are an especially good idea right now. There have always been income limits on who can contribute or convert to a Roth IRA. Currently, for example, if you make more than $100,000 a year (single or married), you cannot convert a traditional IRA into a Roth IRA. But next year that conversion cap will come off: In 2010 anyone can convert a traditional account into a Roth IRA. (Well, almost anyone. Just as married couples that file separately are essentially prohibited from contributing to a Roth IRA, they’re also not able to convert to a Roth.)

This is a fantastic opportunity. Whatever your income, if you have made deductible contributions to an IRA, you can pay taxes on the amount you convert, then never again. And if you have made nondeductible contributions, you will owe income taxes only on the growth in your investments—and, after conversion, never again. (You’ll owe income tax, not capital gains tax, on those earnings because that’s what you claimed the deduction against when you first made the contribution.) You will need enough cash on hand to pay those taxes—it’s better not take a distribution from your IRA to do so. But if you convert in 2010, you can take two years to pay Uncle Sam. (If you convert in 2011 or later, you’ll have to pay the same year.)

This break came from bad lawmaking, and it may well be bad policy. In 2006, Congress was looking for quick revenue and figured that allowing account holders to switch to Roth IRAs would generate $6.4 billion in conversion taxes over the next decade. Unfortunately, the long-term costs of permanently sheltering so many dollars from taxes will be huge—perhaps as much as $100 billion through 2049, according to the Tax Policy Center.

But as long as you can get your savings into a Roth IRA, you’d be crazy not to. Whether you watch your investments grow, spend your money or pass your assets to your heirs, a Roth IRA is the single best way to make your retirement less taxing.