Tax advantages make a Roth appealing to younger workers

Your Money

April 29, 2007|By Tami Luhby | Tami Luhby,Newsday

Concerned that he might not be able to save enough for retirement through his 401(k), Russ Munisteri decided to open a Roth individual retirement account two years ago.

The North Bellmore, N.Y., resident was particularly interested in the Roth IRA because, unlike with his traditional 401(k), he will not have to pay taxes on the IRA withdrawals at retirement. (But he isn't able to deduct his annual contributions to the Roth IRA on his taxes, as he can with his traditional 401(k) plan.)

Munisteri, a computer network administrator, has pumped nearly $6,000 into the account and adds more each month.

"If I save all this money, it's mine," said Munisteri, who persuaded his girlfriend to also open a Roth IRA. "That's the main attraction. What I see in the account is mine. I don't have to worry about paying the government at 60 years of age."

Roth IRAs, as well as the newer Roth 401(k)s, are a smart bet for many people in their 20s and 30s, experts say.

Younger workers are more likely to be in a lower tax bracket now than when they retire, making any current tax deductions less valuable, and they have enough years to save to make the tax-free withdrawals very beneficial.

The beauty of the Roth IRA and 401(k) is that there's no tax on the capital gains in the accounts, so the longer you have to accumulate those gains, the better.

"For young people, it just doesn't pay to get a deduction now," said Rockville Centre, N.Y., financial adviser Ed Slott, author of Your Complete Retirement Planning Road Map: The Leave-Nothing-to-Chance, Worry-Free, All-Systems-Go Guide.

The lack of a deduction "will pay for itself many times over by building a retirement account that will be tax-free forever," Slott said.

As you approach retirement, you need to consider what your tax bracket is likely to be when you stop working and whether it makes more sense to receive a deduction now by contributing to traditional accounts. Also, consider that tax rates are at all-time lows, and many experts believe they will rise in coming years. So you may be better off paying the taxes now than in the future.

Some people may not be familiar with Roth versions of the IRA and 401(k) because they haven't been around as long as their traditional counterparts. The Roth IRA became available in 1998, and the Roth 401(k) made it debut last year.

They are growing in popularity. Roth IRAs held $145 billion in assets in 2005, up from $78 billion three years earlier, according to the Investment Company Institute, a trade group for the mutual fund industry.

About 12 percent of companies offered a Roth 401(k) last year, and another 32 percent are very or somewhat likely to implement it this year, according to Hewitt Associates, a consulting group.

What is the difference between a Roth IRA and 401(k) and a traditional IRA and 401(k)?

The main one involves taxes. With traditional accounts, you can take an upfront tax deduction on your contributions, but you have to pay income taxes upon withdrawing the money at retirement.

With the Roth versions, you receive no upfront deduction, but the money accumulates tax-free.

Although Roth and traditional 401(k)'s differ mainly in tax treatment, many of the other rules are the same: You can contribute up to $15,500 this year, and those age 50 and older can add another $5,000, for instance.

But their IRA counterparts are more complex.

If you do not have a retirement plan at work, you can deduct your contributions to a traditional IRA no matter what you earn. But if you have a pension or 401(k), deductibility starts to phase out if your adjusted gross income is more than $52,000 if you are single and $83,000 if married this year. You cannot deduct your contributions if you earn more than $62,000 if single and $103,000 if married.

If you do not have a retirement plan but your spouse does, the phaseout ranges from $156,000 to $166,000.

For Roth IRAs, your ability to contribute this year phases out if your adjusted gross income is more than $99,000 if single and $156,000 if married. You cannot contribute if you earn more than $114,000 if single and $166,000 if married.

You can put in up to $4,000 in either a traditional or Roth IRA depending on your income. Those who are age 50 and older can contribute an additional $1,000.

Another plus for the Roth IRA is that account owners can withdraw their contributions at any time for any reason with no penalty. Withdrawals from traditional IRAs are limited to higher education, first-home purchases and certain medical and long-term unemployment expenses.

Those who have a traditional IRA may want to convert it into a Roth. But because you will have to pay the taxes on your contributions upfront, you should consider it only if you have enough savings outside the IRA to pay the Internal Revenue Service, said Rande Spiegelman, vice president for financial planning at Charles Schwab.

Right now, your adjusted gross income must be less than $100,000, whether married or single, to be eligible to convert. But that limit disappears in 2010, when you also will have two years to pay the taxes due on the conversion.

If you aren't sure whether to contribute to the Roth or traditional versions of the IRA and 401(k), you could always fund both. For instance, you could put money into a traditional 401(k) at work and then contribute to a Roth IRA.

"You can hedge a little by splitting it up," said John Knapp, vice president at Fidelity Investments.

Tami Luhby writes for Newsday.

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