NEW ROTH OPPORTUNITIES TO SAVE
June 6, 2006
Millions of Americans are saving for retirement in 401(k)s and Individual Retirement Accounts (IRAs). These accounts allow people to invest pretax dollars, but require them to pay taxes on their deposits and accumulated earnings at the time of withdrawal.
By contrast, a Roth account allows individuals to deposit after-tax dollars, but withdraw the accumulated balances tax-free. The Roth method of taxation allows savers to avoid future tax hikes, and given that taxes on retirees will likely be much higher in the future -- due to taxes on Social Security benefits and the cost of Social Security, Medicare and Medicaid -- Roth accounts make sense for many taxpayers.
Which is better, a regular IRA or a Roth IRA? The answer depends on an individual's marginal tax rate while working compared to the rate the taxpayer will face during retirement. NCPA scholars used a financial planning model developed by economist Laurence Kotlikoff to determine whether a Roth account or a regular account is better for workers at different income levels. For example:
- A two-worker family earning $75,000 will face an 18 percent marginal tax rate while working and a 24 percent tax rate in retirement; thus, they are better off with a Roth.
- Families earning between $35,000 and $125,000 face higher marginal tax rates while working than in retirement; thus, they are better off with a traditional IRA.
Congress recently passed a measure that will allow people at any income level to convert traditional IRAs into Roth IRAs beginning in 2010. (The taxes must be paid over the following two years.)
Starting this year, employers can offer Roth 401(k)s. Workers can contribute after-tax dollars, the money will grow tax-free and eventually can be withdrawn tax-free. Unlike Roth IRAs, however, there are no income limits on participation.
Source: Matt Moore and Pamela Villarreal, "Would You Benefit from a Roth IRA?" National Center for Policy Analysis, Brief Analysis No. 554, Tuesday, May 7, 2006.
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