Yesterday, I reviewed the pros and cons of the new Roth IRA. You can set one up any time after the first of the year. Today: Who qualifies to contribute to a Roth IRA, and what about switching the money you already have in a traditional IRA into a Roth IRA?
First, the most you can put into a Roth IRA each year (or into a traditional IRA, for that matter) is $2,000 each for you and your spouse (including a nonworking spouse). What’s more, anything you do contribute to an IRA must be from earned income. So if you earn no money in 1998, even though you may have $1 million in dividends and interest, you can’t contribute to an IRA.
Who earns less than $2,000 a year? Well, kids, for one. And if a child or grandchild legitimately earns some money mowing lawns or designing web sites, then he or she should consider sticking that money into a Roth IRA. The case I made for this last year (and my scheme for getting the kid to go along with it) becomes even stronger with a Roth IRA. The money that accumulates over his or her lifetime will be entirely tax-free at withdrawal. A fantastic opportunity.
Unfortunately for high earners, the allowable Roth IRA contribution begins to phase out for single taxpayers with adjusted gross income over $95,000 and phases out completely at $110,000. For those who file jointly, the allowable contribution begins to phase out at $150,000 and is gone completely at $160,000.
Still that leaves most Americans eligible. (Those who are not can still make non-deductible contributions to traditional, taxable-at-withdrawal IRAs. But with the long-term capital gains rate as low as it is, the case for doing so is less compelling than it was.)
(Note that for the traditional, deductible IRA, there is no income test if you are not covered by an employer-sponsored retirement plan. But if you are, eligibility phases out fast: beginning with adjusted gross income of $30,000 for single taxpayers, $50,000 for those filing jointly.)
If you qualify to contribute to a Roth IRA, good for you. As discussed yesterday, you may want to set one up.
Now what about switching the money in your current IRA into a Roth IRA?
This can be done with no penalty, even if you’re not yet 59-1/2. But you can only do it if (a) your adjusted gross income is $100,000 or less, and (b) you pay tax on the money you transfer. If you’re switching $30,000 from a traditional IRA to a Roth IRA, and you’re in the 35% tax bracket (federal and local), that would be $10,500 in tax. For transfers made in 1998 only, the IRS will allow you to pay the tax over four years. (State income tax departments may or may not follow suit. I’m not sure whether that’s been worked out.)
This would make sense if you’re in a low tax bracket now (and would remain in a low bracket even with this added income from the transfer) but you expect to be in a high one when you retire. You’re young, living in a no-tax state now and are in the 15% federal tax bracket. You figure that by the time you retire, all states will have hefty income taxes and you’ll have accumulated enough other investment income to throw you into a high federal tax bracket.
On the other hand, if you’re in a fairly high tax bracket now — or would be if you withdrew $80,000 from your IRA this year! — it makes little sense to do so unless you expect your tax bracket to be high when you retire as well.
[Note: I assume, but do not know, that the states will follow Uncle Sam’s lead in exempting withdrawals from Roth IRAs from tax.]
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