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Deadline nears for special Roth IRA provision

Posted online

by Eric Kurth

for the Business Journal

Psst! Looking to convert a traditional IRA to a Roth IRA? Well don't overlook a special one-time offer that expires this year.

Investors converting their traditional IRAs to the new Roth IRA are going to owe income taxes. But the good news is that the taxable income can be spread over four years (tax years 1998-2001), if investors act on or before Dec. 31, 1998.

The Roth IRA is one of the most significant investment opportunities to come along in decades, making conversion to a Roth worth serious consideration.

Who should convert? If the income taxes you pay now can be offset by the Roth IRA's tax-free growth before you retire, it's a good idea to look at conversion.

And if you expect to be in a higher tax bracket at retirement, remember qualified Roth distributions are tax-free, unlike traditional IRA distributions.

Each situation requires a thorough financial analysis to determine the best solutions, but both a conversion Roth and a contributory Roth IRA offer unique advantages.

To make the right decision, taxpayers need to weigh the number of years they have until retirement, their current and future tax brackets, and their estimated investment returns.

Why a Roth IRA? It can be an excellent investment opportunity. With a traditional IRA or an employer-sponsored retirement plan, taxes are deferred until you withdraw funds. By contrast, the Roth IRA allows your investment earnings to grow tax-free and, when you withdraw funds, no federal taxes are owed on any dividends or capital gains earned.

To qualify, you must hold the account for five years, then funds can be withdrawn under one of several conditions: when you reach age 59 1/2, become disabled or die, or for qualified first-home purchases.

Roth offers fewer restrictions. A Roth IRA can be an effective investment tool for people of all ages, providing tax-free retirement income in addition to Social Security benefits or an employer's retirement plan. Besides its tax-free provisions, the Roth IRA offers several advantages over the traditional IRA:

?The ability to contribute past age 70 1/2, an important consideration given that more Americans are staying in the work force longer and living longer.

?No mandatory age at which you have to begin withdrawing funds (traditional IRAs mandate withdrawals beginning at age 70 1/2).

?The ability to pass the Roth to heirs income-tax-free (except for estate taxes), if the Roth IRA is at least 5 years old when the beneficiary takes distribution.

?Tax-free distributions before age 59 1/2 due to disability or death, if the Roth IRA is at least 5 years old.

The Roth IRA does impose income limits on participants. For example, single persons can make an annual after-tax investment of $2,000 if their adjusted gross income is less than $95,000. Couples can invest $2,000 each if they file jointly and if their combined adjusted gross income is below $150,000. Regardless of marital status, you can convert an existing IRA into a Roth provided your income is less than $100,000.

Tax savings add up. The tax savings can be significant between a Roth IRA, whose distributions are tax-free, and a traditional IRA, whose distributions are taxable. In a hypothetical case, assume you are in a 28 percent tax bracket and contribute $2,000 at the beginning of each year at an assumed 8 percent annual rate of return.

After 30 years, both the Roth and traditional IRAs are worth the same amount. However, after taxes, the traditional IRA nets only $160,326, while the tax-free Roth nets $244,692.

(This example assumes a growth rate for illustrative purposes only and does not reflect the actual performance of any specific investment, nor does it factor in the benefits of the potential tax deductibility of traditional IRAs.)

The potential tax advantages of a Roth IRA are the most significant improvement since the inception of IRAs more than two decades ago.

Every investor needs to consider a Roth IRA, based on their own financial needs and circumstances, preferably with the help of a personal financial advisor, and a tax adviser, too.

(Eric Kurth is a financial advisor with Waddell & Reed in Springfield.)

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