Why Have a Roth IRA for Older Investors?
IRAs, or individual retirement accounts, are typically used to save money for retirement. The advent of the Roth IRA has left many investors wondering if they should open a Roth or convert their existing traditional IRA. The question becomes potentially vexing if you are an older investor. Not only should you take your time horizon into account, but you also need to consider your current and future income and tax situation.
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The Basics
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You need to know how traditional and Roth IRAs differ in order to make an informed decision. With a traditional IRA, you can deduct money you put in from your taxable income. While you receive a tax break a the time of your deposit and the benefit of tax-deferred growth, the IRS requires that you pay income taxes on traditional IRA distributions, or withdrawals, at your tax rate at the time of the distribution. Roth IRA contributions are not tax-deductible, but when you access Roth IRA money, starting at age 59 1/2, the money can be removed without being taxed.
Roth IRA Conversion
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The IRS allows you to convert your traditional IRA to a Roth IRA. If you do this, however, the IRS charges income tax on any untaxed amounts in the traditional IRA. For example, if you made a $2,000 tax-deductible contribution to a traditional IRA and then converted it to a Roth, you must pay income tax on the $2,000. As Dan Caplinger of the Motley Fool explains, if you think you will be in a lower tax bracket by the time you access your retirement funds, a conversion might not make sense. If you are older and expect your income to drop significantly upon retirement, a Roth conversion could be a bad idea. Reason being that with an lower income, you will be in a lower tax bracket, meaning that your taxes on a traditional IRA withdrawal will be significantly lower. Additionally, you might benefit from the tax break a traditional IRA contribution provides when you are earning more money.
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Opening a New Roth
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Similar considerations apply if you are an older investor contemplating the notion of opening a new Roth IRA. Since every situation is unique--and the subject relatively complicated--consult your tax advisor for specific advice. Generally, though, you need to decide if it makes sense to pay income tax on money now or when you take distributions. If you are 50 years of age, for instance, and sit in the highest tax bracket, the immediate tax benefit of a traditional IRA might make sense, especially if you see your tax bracket dropping come retirement. If you think your tax rate will rise, it might be wise to opt for the tax-free withdrawals that come with a Roth IRA.
Required Distrbutions
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As IRS Publication 590 on IRAs states, you can begin taking IRA distributions, penalty-free, at age 59-1/2. With a traditional IRA, however, the IRS requires that you begin taking out money by age 70-1/2. Roth IRAs do not live by such a mandate. This might make them attractive for older investors who do not need the money right away. By keeping the money in a Roth IRA, the interest continues to grow tax-free.
Warning
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Caplinger sounds a warning for older investors looking to convert to a Roth IRA. If you convert a chunk of money from a traditional to a Roth IRA, you pay taxes on that cash. If the investments you place that transfer in lose money, you, as an older investor, likely have less time to wait for those investments to rebound. Therefore, you will have paid taxes on a larger amount than your account is now worth by converting.
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References
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