Dear Carrie: I have a couple of 401(k) accounts that I rolled over into an IRA. My understanding is that any rollover is considered a "traditional" IRA. In addition, I'd like to add the max $5,000 a year into an IRA, but I feel that a Roth might be the best option. Would it be better to add to the IRA I've already got? Or add the $5K a year to a new Roth IRA? -- A Reader
Dear Reader: As tax advantaged retirement savings accounts, both a traditional IRA and a Roth IRA have their advantages. The first gives you tax benefits upfront, the second provides tax savings down the road. For young people just starting out who will most likely be in a higher tax bracket later on, a Roth IRA may be the best choice. For those in their peak earning years -- who can benefit more from the tax break now -- a traditional IRA likely makes more sense (and may be the only option).
However, for some folks, the possibility of having both types of IRAs working for them is the ideal. That's because having both a traditional and a Roth IRA can be a good way to help control your income tax bill when it comes time to make withdrawals. So, I'm glad you asked this question because it opens the door to looking at a Roth not only as a way to save for retirement but also as a part of your retirement tax strategy. But before you think about long-term tax planning, you first have to determine if you qualify for a Roth now.
DECIDING IF A ROTH IRA IS RIGHT FOR YOU
A Roth IRA is attractive for a number of reasons. Earnings grow tax-free; you don't pay income taxes on qualified withdrawals; and because contributions are made with after-tax money, you can withdraw them at any time without paying taxes or penalties. But no matter how good it sounds, a Roth doesn't fit the bill for everyone.
The first consideration is the income limitation. While income restrictions were lifted this year for Roth conversions, restrictions on new Roth IRAs remain. If you're single, your ability to contribute to a Roth IRA for tax year 2010 phases out between $105,000 and $120,000 of income. For married filing jointly, contributions need to be between $167,000 and $177,000.
You also want to consider your tax bracket now and in the future. If you expect to be in a higher tax bracket when you retire, a Roth makes sense because, while contributions aren't tax deductible, qualified withdrawals are tax-free. If you anticipate being in a lower tax bracket when you retire -- and it's more important to get the upfront tax deduction now rather than the tax-free withdrawal later -- contributing to your traditional IRA may be the better choice.
USING A ROTH AS PART OF YOUR RETIREMENT TAX STRATEGY
If you qualify for a Roth, opening one now to complement your traditional IRA can make good tax sense come retirement time. With both types of IRAs, you can strategically balance your yearly withdrawals to help control your tax liability. For instance, you could plan to take a taxable distribution from your traditional IRA up to a certain amount, and then switch to taking tax-free distributions from your Roth to avoid bumping yourself into a higher tax bracket.
Another strategic plus is that there is no required minimum distribution (RMD) for a Roth at age 70 1/2. This allows you to keep your Roth IRA money growing, even while you take RMDs from your traditional IRA. A Roth may also fit into your estate planning strategy, since inherited Roth assets are tax-free to your heirs.
EXPANDING YOUR OPTIONS
You say you've rolled over a couple of 401(k)s, but you don't say if you're still able to contribute to an employer's plan. If you are, keep contributing as much as you can and take advantage of any employer match. The IRS allows you to contribute to both a 401(k) and an IRA at the same time, although your IRA contribution will not be tax-deductible if you or your spouse is an active participant in a retirement plan at work and you earn over the limit. Along the same lines, some employers offer both a traditional and a Roth 401(k) and let you split your contributions between them. So check into all your options. And don't forget to up your IRA contribution to the maximum (currently $6,000) when you turn 50.
There's no telling what future tax rates and tax laws will be, so it's wise to maximize your opportunities to increase your retirement savings now -- as well as strategize for tax savings in the future. Sounds like you're on the right track.