M E R I D I A N     M A G A Z I N E

Traditional vs. Roth IRA’s: Tax Shelters for Normal People
by Richard P. Halverson

So if they are for normal people why can’t normal people understand them?

The Individual Retirement Account or IRA is designed by our benevolent government to encourage you to save for your retirement. To do this the government provides certain tax incentives. To make sure you don’t squander the money before your retirement they put on certain restrictions. There are now two types of widely used retirement IRA’s: the so-called traditional IRA and the newer Roth IRA. I will compare the two and try to offer some thoughts about how you can determine which is best for you. I will address one question up front — should you have an IRA? YES! (If you can qualify.)

THE IRA IS AN ACCOUNT, NOT AN INVESTMENT

First let me explain that an IRA is a type of investment account. An IRA is not a type of investment. I am sure many readers know this so they can skip this section. Over the years I have found a lot of people confused about the difference between the IRA account, which has a lot of restrictions, and the investments that may be in the IRA account, some of which may have a lot of restrictions.

The IRA itself is an account that you have with a financial institution. Nearly all kinds of financial institutions offer IRA’s. This includes banks, mutual fund companies, brokerage houses, etc. What distinguishes the IRA from other accounts you may have at that same institution are the special tax rules associated with the IRA.

If you abide by all the rules the government will give you certain tax breaks on the assets and earnings in your IRA. So, you can have an IRA and a regular brokerage account at Merrill Lynch. You can hold exactly the same investments in both. But your IRA will do better because of the tax advantages.

Often the type of institution greatly influences the type of investment you have in the account and here is where the confusion arises. For example, you may have an IRA at a bank. You may invest in a certificate of deposit, which is an investment found exclusively at financial institutions insured by the government like banks. Because this is the only place to get CD’s it is easy to think the IRA and the certificate of deposit are the same. They are not. The investments you hold in your IRA will probably be influenced by the financial institution where you have your account. If you open an IRA with Dreyfus you will almost certainly invest in Dreyfus Mutual Funds. If your IRA is at the brokerage house of Smith Barney you may invest in individual stocks and bonds. I have already made the point about banks and CD’s. These connections are getting much fuzzier as the financial institutions get into each other’s businesses. But it is still true that you will often choose your financial institution because of the types of investments you want to make. Incidentally, you can open IRA’s at as many different institutions as you want as long as your annual contributions don’t exceed the limits. Having accounts at multiple institutions is probably an inefficient idea unless you just love opening mail every quarter from banks and brokers. The rest of the article will deal only with IRA’s as accounts and very little with the investments that may be held within the IRA.

IRA AS AN ACCOUNT

Individual retirement accounts have been around for several decades. Congress passed legislation granting qualifying individuals substantial tax breaks if they would save money for retirement. Because of the tax advantages, and despite their restrictions, IRA’s have always been a superior way to invest money versus investments in fully taxable accounts. Ordinary individuals do not get a lot of tax shelters. They need to take advantage of them when they can.

Because IRA’s are a creation of the government congress has found itself unable to resist meddling with them all the time. So, the rules keep changing. The last important change occurred in August 1997. (Effective January 1998.) That is when congress passed the Taxpayer Relief Act. This legislation made changes to the traditional IRA. It also created the Roth IRA (named after the senator who sponsored the bill) and the Education IRA. Financial planners and the institutions they work for have heralded this legislation, particularly the creation of the Roth IRA. I’m happy for the legislation too. It does some good things for people. Unfortunately, it also complicates the entire picture tremendously.

The legislation is supposedly aimed at helping ordinary Americans. Regrettably ordinary Americans can’t understand it without the help of professionals. I believe congress could have written a law that simplified things. For example, I see no reason at all why we need a traditional and a Roth IRA. They both have the same basic goal i.e. encourage retirement savings by offering tax incentives. But each has its own set of rules, restrictions, benefits and failings. Talk about financial baffelgab. I don’t think an article like this one should even be necessary. No wonder the financial planners are ecstatic. Instead of the Taxpayer Relief Act congress might have called it the Financial Planner Protection Act.

TRADITIONAL vs. ROTH IRA COMPARISON

Here is a summary of the basic characteristics of each.

QUALIFYING FOR AN IRA

There are several criteria that determine if you qualify to contribute to a traditional or Roth in a given year. You may qualify one year and not another. They include:

• Marital status. Both your marital and your tax filing status are important.

• Retirement coverage at work (covered). If you are a participant in a plan at work where you or your employer or both are contributing money into a retirement account you are covered. Work coverage includes plans like pensions, profit sharing, 401k, 403b, Keogh, SEP IRA, etc. (Incidentally, if you have a work plan, such as a 401k, where you can make contributions, it is nearly always better to max that out before looking at either the traditional or Roth IRA’s. I have seen advertisements encouraging people to open Roth’s and forgo contributions to a 401k. They are trying to sell you something. Rarely, will this be a good idea.)

• Income. The law looks at adjusted gross income AGI and modified adjusted gross income MAGI. AGI is essentially the figure on your tax form used to calculate your income tax. MAGI adds to your AGI things like foreign income certain foreign living expenses etc. It is complicated. If you have any of these be alert.

To get an idea if you can make IRA contributions this year find your marriage and coverage status below. Bear in mind while you may have both a traditional and a Roth IRA amounts are combined i.e. your combined contributions may not exceed $2,000.

SINGLE and COVERED

MARRIED, FILING JOINTLY and NEITHER COVERED

MARRIED, FILING JOINTLY and ONE SPOUSE COVERED

MARRIED, FILING JOINTLY and BOTH SPOUSES COVERED

MARRIED, FILING SEPARATELY and NEITHER COVERED (Following applies to each spouse separately)

IT’S ABOUT SAVING TAXES

So which is best for you??? As you can see that is not a simple question. However, both are designed to offer tax advantages so that is a critical question. The answer depends on your current tax rate compared to what you believe will be your tax rate in retirement.

It is somewhat unusual to expect to be in a higher tax bracket after you retire than you are during your working years but it does happen. Further, I usually believe saving taxes up front is better than saving taxes later on. Consequently, from simple tax savings point-of-view the traditional IRA should get first consideration.

CONVERSION TO A ROTH

There is one more feature of the Roth IRA that should be discussed. The law allows you to convert existing IRA’s to Roth IRA’s. This includes the traditional IRA’s I have been discussing as well as SEP and Simplified IRA’s. The advantage in doing this goes to the greater flexibility of withdrawal during retirement associated with the Roth IRA. But there are some big barriers to consider before you get excited.

If you convert you will need to pay taxes on all the money coming out of your existing IRA. Please note this will hit your current income and may possibly push you into a higher bracket. The money will be taxed at your highest marginal rate. If you plan to use some of the money from your current IRA to pay the tax you will also trigger a penalty on those funds. Otherwise you can pay the tax out of other resources. Then even if you can swallow the immediate tax consequences you can’t do it at all if your modified adjusted gross income exceeds $100,000. This feature has been getting a lot of hoppla from financial planners. But I think it takes some rather unusual circumstances to make tax sense. Use a very sharp pencil before doing a conversion.

AN ON-LINE CALCULATOR CAN HELP

IRA’s are great ideas. I am all for saving and I am all for tax incentives. I do wish congress would greatly simplify everything and make them much more widely available. But if you can take advantage of them — do so. I believe you will find using an IRA calculator helpful. You can find them on-line from many big financial institutions. I am not promoting any web site — except Meridian, of course — but the calculator on Quicken’s home page is a good one. The homepage is quicken.com or quicken.com/retirement/RIRA/planner/html/notemplates/frameset.htm to go directly to the calculator.

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