Roth IRAs Save Dessert for Last

By Martha M. Hamilton
Sunday, December 31, 2006

Andrew C. Baird III is off to a great start, already putting money into an employer-sponsored retirement savings account at age 22. But he wonders whether he would be better off steering his savings into a Roth individual retirement account outside of the workplace.

Baird, who graduated in May from Trinity College in Hartford, Conn., has been working at the Orvis Co. store in Clarendon. It has been a good temporary gig for him -- he's an avid fly fisherman -- while he looked for a more serious post-college direction. Orvis offers a 401(k) plan, and Baird is taking advantage of it, depositing about 10 percent of his income there.

"When you're getting paid hourly, that's a substantial amount," said Baird, who is living with his parents in Arlington.

Baird is on the brink of changing jobs, but he raised the question about switching his 401(k) money into a Roth IRA before the new opportunity came along. It was prompted by comments of a friend, who said he was switching to a Roth to have more control of investments and to be able to invest more aggressively. Both ideas appealed to Baird, though he doesn't have much money to manage right now -- about $400.

I put Baird's question to two experts on financial planning for retirement and asked them what others should consider when deciding whether to open a Roth IRA. If you qualify for a Roth IRA, you have until the tax filing deadline in April to make a contribution for 2006.

First let's spell out the basics. In a traditional IRA, deposits are made with pretax dollars. The money goes into savings, reducing your taxable income and therefore the taxes you pay. But after you withdraw the money at retirement, you pay taxes on your contributions and the money you've made through investments.

In a Roth IRA, the dollars you save already have been taxed, but when you start withdrawing money, both contributions and earnings will be tax-free, assuming you're 59 1/2 and the account has existed for five years. There are income limits on eligibility for a Roth IRA. (See box, above right).

You can contribute to a Roth IRA in addition to an employer-provided savings plan such as a 401(k). In the future many companies are likely to offer, as part of their 401(k) plans, a Roth 401(k) option that would not have income cutoffs. We won't get into the rules for those or for converting a traditional IRA to a Roth in this column.

Dallas Salisbury, who heads the Employee Benefit Research Institute, and Christine S. Fahlund, senior financial planner for T. Rowe Price, said there are several good reasons to invest in a Roth IRA if you are eligible.

It makes sense especially for someone like Baird, who is young and at the beginning of his career, because he is likely to be paying lower taxes now than in the future, possibly even in retirement. But investors in higher brackets may also face increased taxes in the future as Congress struggles to keep up with spending needs and to close the budget deficit.

Salisbury says he always tells his own family that the current budget situation, along with questions about long-term funding of Social Security, means there's a greater chance of future tax increases. With that in mind, "an individual is always going to be better off putting dollars that aren't matched into a Roth or a medical savings account, anything that says you won't pay taxes when it comes out," he said.

When Salisbury says "matched," he is talking about the matching contributions employers often make on behalf of participants in 401(k) plans, sometimes dollar for dollar up to a certain percentage of salary. If you have your money in a 401(k) plan with a company match, it makes sense to contribute enough to capture those matching funds.

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