The gold rush has begun. Banks, mutual funds, and brokerages are hitting the newspapers, the Internet, and your mailbox with a fury to persuade you to open or switch an individual retirement account. With the 1997 Taxpayer Relief Act, savers have a confusing welter of choices: three different IRAs, with the flexibility to convert old accounts into new forms. That's not to mention all the possible investment options.
How to sort it out? First, you have to understand the differences between deductible, nondeductible, and Roth IRAs, your eligibility for each, and their pros and cons. (We won't even discuss the new Education IRAs, because they're not really IRAs.) Then, you might want to crunch some numbers, with computer software such as T. Rowe Price's $9.95 IRA Analyzer or the IRA calculators on the Web sites offered by mutual funds. Finally, you'll be ready to tackle two questions: Should you convert your existing IRA to a Roth IRA? And where should you put future IRA contributions?
TWO FLAVORS. Start with the basics. Since the 1970s, IRAs have come in two flavors: deductible and nondeductible. Individuals who aren't covered by an employer's retirement plan can deduct up to $2,000 in IRA contributions. Workers with pensions can take deductions only if their income is below the law's limits: Couples with joint adjusted gross income (AGI) up to $50,000 can deduct $2,000 each, as can singles earning up to $30,000. (The deduction phases out for a joint income of $60,000, single income of $40,000.) For couples earning between $50,000 and $150,000, the new law now considers each spouse's individual pension status. If the husband is not in an employer's retirement plan at work, but the wife is, he can take a $2,000 IRA deduction, but she can't.
Anyone who doesn't qualify for an IRA deduction can still sock away up to $2,000 annually in a nondeductible account. Those people take advantage of the IRA's second tax benefit: Money earned accumulates tax-free. For both of these traditional IRAs, funds are taxed when they are withdrawn.
But now there's a better option--the Roth IRA. For this version, contributions are also nondeductible. But when you take money out of a Roth IRA, Congress promises the withdrawals will be totally exempt from taxes. (Well, not always: The account must be five years old, and the owner 59 1/2, for tax- and penalty-free withdrawals.) Couples with joint AGI of up to $150,000 can put $2,000 apiece into a Roth IRA, as can singles with income up to $95,000. (The contribution limit then shrinks as income rises, to zero at a joint income of $160,000 and a single income of $110,000.)
Clearly, a Roth IRA's tax-free withdrawals beat a non-deductible IRA's taxes-due payout. The math is tougher for those taxpayers who qualify for deductible IRAs, but the bottom line is simple: The Roth IRA almost always produces more aftertax income--in many cases, an extra $100,000 or more over a retiree's lifetime.
To make a sweet deal even sweeter, Congress decided to allow owners of traditional IRAs to switch their funds into the new accounts. The drawback: When you make a "Roth conversion," you have to pay taxes on any past IRA deposits you deducted, plus any earnings your IRA has accumulated. (These accelerated tax collections--projected to net billions over five years--might have had something to do with Congress' generosity.) Savers who switch in 1998 can spread the tax bill over their '98, '99, 2000, and '01 returns. Those who decide to wait will have to pay the taxes in the year of the conversion.
LOOMING PENALTY. Should you convert? First, you must pass two tests. Your 1998 income must fall below $100,000, whether you file a single or joint return. (A married couple filing separate returns can't convert IRAs.) And you must come up with cash, from either savings or borrowings, to pay tax on the converted money, which also might push you into a higher income-tax bracket. Right now, it's possible to pay the tax with your IRA assets, but Congress is on the verge of creating a penalty for that approach. Besides, drawing down your IRA defeats the purpose of stuffing away tax-favored savings.
Financially, a conversion pays off quickly: A Roth IRA earning an 8% return produces more aftertax income than a similar traditional account in just five years, according to Price's IRA Analyzer. The payoff takes longer if your tax rate drops in retirement: A saver who pays conversion taxes at the 28% rate, but expects to be in the 15% bracket in retirement, needs to let IRA earnings accumulate 12 years without withdrawals to come out ahead.
If you want to see the numbers for yourself, check out some of the computerized calculators investment houses are offering. Enter your age, income, and other data, and they'll tell you what IRA options you can take and which offer the best lifetime payoff. To compare conversions, you'll need your existing IRA balance and what share of that represents nondeductible contributions. Price's IRA Analyzer (800 333-0740) comes on CD-ROM or floppy disk and allows you to store detailed reports on your computer.
On the Internet, you'll find calculators at Web sites for the Strong Funds (www.strong-funds.com), Vanguard (www.vanguard.com/cgi-bin/Roth), and many other mutual-fund companies.
SURPRISING TREND. One surprising trend is that financial planners report strong interest in conversions among well-heeled seniors, including retirees. That's because the Roth IRA offers an unheralded advantage: While traditional IRAs force retirees to start withdrawing funds the year they turn 70 1/2, the Roth IRA has no minimum required distribution. And a retiree can choose to bequeath the Roth IRA to a beneficiary--a child or grandchild, say--who then can enjoy an annual tax-free distribution for a lifetime. In contrast, traditional IRAs bequeathed to anyone other than a spouse must be cashed out within a year.
Those perquisites are attracting interest in the Roth IRA as an estate-planning tool. Roth IRA balances are subject to the estate tax, but that can be paid from other assets.
For younger savers, it's hard to find a scenario in which a Roth conversion doesn't pay off. The biggest obstacle is likely to be the upfront tax bite. If that's too hard to swallow, you can convert just part of your IRA. A 1998 stock-market correction could unleash a flood of conversions, because depressed share prices will mean less of a tax tab when the funds are converted. (You get to pick which accounts you convert from an old IRA into a Roth IRA. But the share of the converted account that's taxed depends on the ratio of nondeductible contributions to total balances in all your IRA accounts.)
What could go wrong? Well, you could switch your IRA, then discover early next year that you earned $100,100 in 1998--too much for you to qualify for the conversion. As the law's now written, you would be in deep trouble: Your Roth IRA would be canceled, but you wouldn't be able to restore your traditional IRA. You would owe taxes on the full account on your 1998 return, and you might face a 10% early-withdrawal penalty. Oops!
Congress set out late last year to remove that draconian threat, debating legislation that would allow IRA converters who misjudged their eligibility to reverse the deal and restore their traditional IRA. But that measure hasn't passed yet. If your '98 income is likely to hover around $100,000, you'd be wise to hold off on any IRA conversions until the penalties are reduced or you're sure you will qualify.
POLITICAL RISK. Then there's political risk. In a Roth conversion, "you pay extra taxes now on Congress's promise that you won't pay taxes later," says financial planner Michael Hengehold, president of Hengehold Capital Management in Cincinnati. "What if Congress reneges?" There's precedent--the recently repealed excise on "excess distributions" from retirement plans--for levies on savers whose success incites political jealousy.
But other tax experts say that's unlikely. "You can never predict political shifts," says John Gardner in the Washington tax office of accountants KPMG Peat Marwick, "but all the signs point toward greater incentives for savings, not less." A wave of IRA- and 401(k)-savvy baby boomers sweeping toward retirement should provide a check on moves that punish savers.
So relax and enjoy your IRA choices. Sure, they're complicated. But they're rewarding enough to be worth the labor of mastering them.