Roth IRAs Grab Spotlight Amid New Tax Law

Retirement experts seeking to wring some benefits out of the new tax law have turned in part to a perennial fail-safe: the Roth IRA.

The Roth has been a popular tool for a variety of goals ever since its creation in 1997. Unlike typical IRAs, the Roth requires that investors contribute money after it has been taxed. Once the Roth has been open for five years, all distributions are completely free of tax, provided certain conditions are met (you're 59-and-a-half years old, disabled or dead). You're also able to withdraw up to $10,000 in gains if the proceeds are used to purchase a home. (Since your contributions have already been taxed, they can always be withdrawn tax-free.)

Many of the perks in the new law could persuade investors to put less in their retirement accounts. To reap any benefit from the low 15% rate on capital gains and dividends, for instance, those stocks and funds need to be held in taxable accounts. (In tax-advantaged accounts such as traditional IRAs and 401(k) plans, gains and dividends aren't taxed at all until the investor takes a distribution, at which point the entire distribution is taxed at ordinary income tax rates. For reasons why these accounts still offer the most bang for your buck, see Tax Law Shouldn't Alter Your Behavior.)

But the new law also broadens the 10% tax bracket -- in 2003 and 2004 the bracket ends with taxable income of $14,000 for joint filers, and at $7,000 for single filers. (In 2005 it goes back down to $12,000 and $6,000; the 10% tax bracket disappears entirely in 2011.) And that's good news for investors who are interested in converting their existing IRAs to a Roth IRA. Since the money that's converted is taxed as ordinary income, the lower rates enable investors to convert more money at the lower income tax rates. That provides many people -- retirees in particular, who are often in the lower tax brackets -- with a good opportunity to convert existing IRAs to Roths far more cheaply than previously possible. (For more on Roth conversions, click here and here.)

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