Roth IRAs

[Guest Stiggy]

Hi folks. I have a daughter that would like to invest in IRAs. She is 20 years old and is working part time while in College.

I assume(since her income is low) that she could open a deductible IRA(for the upfront tax relief) and then later on(what is the time period) convert it to a Roth IRA for tax free purposes at retirement.

Appreciate your help.

[papogi]

I would recommend going Roth from the beginning. She can convert a regular IRA to a Roth anytime, but if the regular IRA is made entirely of deductible contributions, the full account value becomes taxable income upon the conversion. If you expect her to have greater income later, she will be in a higher tax bracket. The conversion to the Roth would then be taxed at her marginal income tax rate at that time. Keep it simple and go Roth now.

[Guest Stiggy]

Thanks for your reply. My thoughts were that if she goes with the traditional deductible IRA she could realize the upfront tax savings since it would be adjusted to her income for 2002.

Then I thought she could convert it over to the Roth for the long term.

I didn't think you could deduct the amount you put into a Roth IRA from your taxable income like the traditional? Am I mistaken?

Appreciate your help.

[John G]

You did not indicate her total income, but from the sounds of it she is probably on the low end of the 15% bracket. If the IRA gets $3,000 then you get a tax savings of no more than $450 right now, and it could easily be less if her income is very low or you drop a tax bracket.

Lets assume that she puts $3,000 in 2002 into a regular IRA and takes the immediate tax break. If we assume that your daughter is about 20 and keeps the funds sheltered for 40 years at an annual rate of 10% (a common number for mixed stock/bond fund) then she will have over $135,000 at age 60 from just this first year contribution. If she then took an income stream perhaps 10% she would have taxable income every year for the rest of her life of $3,800. Assuming a likely 28% rate and upon her death the remaining assets (which could easily be above 50,000) would also be taxed, perhaps triggering a tax bill of $14,000.

Perhaps you should post a specific income number, tax rate, and filing status for your daughter so we can give you a more precise answer.... but I would join Papogi and recommend a Roth now. The Roth will also have $135,000 from growing just this initial 3k, but there will be no specific required dispursement and what every does come out will be tax free. That is a pretty good deal, even if future dollars must be discounted for inflation. For some folks, every $3,000 put into a Roth buys a year of retirement since it comes out tax free. What a system!

She does not have to put the money into the IRA. Anyone can fund it for her.... like mom and dad... or perhaps offer a dollar for dollar match to encourage her. Besides getting her an early start in building a retirement next egg, she will also get early lessons on investing. I would highly recommend that you have her read the March issue of Consumer Reports and encourage her to pick a balanced NO-LOAD mutual fund from the ones they list.

Conversion of a regular IRA may not always be an option. Plus, you pay taxes on the appreciated assets not the initial contribution.

Conclusion: Roth is probably the better option.

[Guest Stiggy]

Thanks again. Let me try and be more specific. I'm new on this board....

Daughter is 20 years old, annual income of ~ $16, 000...

I agree with you on the Roth IRA idea. But, I was wondering if the following is a valid approach:

1st, put the 3k into a DEDUCTIBLE IRA for tax savings($450 as you mention)..

2nd, MOVE that money immediately to a ROTH IRA for the tax free opportunities at retirement(is there a holding period needed for the deductible IRA deposit or can this be converted immediately)???

That is my actual question. Sorry for the confusion...

Does this make sense to you?

Appreciate your time.

[John G]

No, your plan does not work. Here is why. When you do step two conversion, you pay tax on the full amount of the account since you took the deduction on all contributions. You therefore owe $450 taxes you just thought you saved. Given the facts you have provided, I would go the Roth route since your daughter is in the 15% tax bracket which she is unlikely to see much longer.

[JAMES PATRICK]

I've got a better idea. If her income is $16,000 this year you have her put $1000 in a Traditional which will bring her AGI to $15,000.

Then she can put at least $1000 in the Roth(max is $2000) and with the Credit this year she will wipe out her tax liability of $795.

So she will make $16000, put $1000 in a Traditional, get a $3000 exemption,a $4700 standard deduction and pay NO taxes on her taxable income of $7300 as long as she puts at least $590 into the Roth, for the 50% credit.

Isn't this country wonderful?

[John G]

Patrick,

Not so fast. Students are specifically prohibited from the benefits of the IRA credit. See below:

http://www.rothira-advisor.com/economicgrowth.htm

If your adjusted income is low enough and you meet other eligibility requirements, you will receive a tax credit of up to 50% for your contribution to an IRA or other eligible retirement plan. (Students and dependents are excluded.) For example, if you are a single mother with an adjusted gross income of $22,500 or less and you contributed $2,000 to an IRA, you would get an income tax credit of $1,000. This credit is in addition to any deduction you may be eligible for. However, in general, I would prefer the contribution be to a Roth IRA rather than a traditional IRA or retirement plan.

That seems like a nice break for low-income taxpayers until you think about it for a minute. What single mother with an adjusted gross income of $22,500 or less can afford to make a $2,000 IRA contribution, even if their true after-credit cost would be $1,000?

As a practical matter, I intend to take advantage of this provision by telling my wealthy clients to give money to their children (or grandchildren) and have the children use the money to make an IRA contribution.

Example: Your single daughter (not a dependent or full-time student) earns $15,000. You give her $2,000 to contribute to her IRA. She makes the Roth IRA contribution and also gets a $1,000 tax credit........

My addition: this option makes a lot of sense the year she graduates and has a job for only perhaps 6 months. So keep this in mind for her senior year. I have trouble imagining children that have income to qualify for an IRA but are not students, so the suggestions above are very limited.

[Guest Stiggy]

Thanks everybody for your replies. It seems that our friends at the tax office don't like students putting in deductible IRA contributions(I guess they figure working is for supporting the College education)!

I'm glad you gave me this input as I had no idea that students couldn't utilize a deductible IRA.

I think she still will fund the ROTH now and if it makes sense go with the deductible IRA as you suggest once she finishes college(based on her income level at that time)..

Again, thanks so much for your time and input!

[John G]

Wooaaa. What students can not utilize is the special credit for IRAs when you have low income. This is totally separate from the deductability issue.

I would still recommend the Roth. Tell your daughter she has the right idea and encourage her to stay with the plan.

[Guest Nighthawk]

Example: Your single daughter (not a dependent or full-time student) earns $15,000. You give her $2,000 to contribute to her IRA. She makes the Roth IRA contribution and also gets a $1,000 tax credit........

It is impossible to receive a $1,000 tax credit on a single person's adjust gross income of $15,000. You cannot receive more credit than you have tax due. When the tax rate was lowered from 15 to 10% on the first $6,000 it makes it impossible to claim the entire amount. $795 would be the approximate maximum credit if you were to make exactly $15,000 and receive the 50% savers credit.

NH

[John G]

IRA tax credit issue is moot. She is a student and students, by law, do not qualify. This is not even fine print. They DON'T qualify.

[Guest Nighthawk]

I sorry I wasn't clear in my post. I should have indicated a non-student or qualified person with that amount of income could not possibly receive a $1,000 saver's credit.

NH