Tax Cut for Savers

By Daniel Kadlec

Sometime this week President Bill Clinton is expected to sign a sweeping IRS-reform bill that includes "technical corrections" governing the popular Roth IRA. Mostly, the corrections close loopholes. So don't look for any big changes, like expanding eligibility for those earning more than $100,000 a year. As I've argued before, that low limit unfairly precludes many nonwealthy couples in big cities from converting their old IRAs to a Roth. Still, nagging obstacles are about to get obliterated, opening the door for wider use of this powerful savings tool.

The Roth is, of course, the now familiar IRA that allows savers to contribute aftertax money, which grows tax free and can be withdrawn tax free in retirement. Traditional IRAs are funded with pretax money that grows tax deferred but is subject to tax upon withdrawal. Here are three key corrections in the bill that relate to the Roth:

--You will be allowed to convert an existing IRA to a Roth, and you can wait until you file your tax return to revert to the old IRA penalty free. That means that if you expect to be just under the income limit, you can convert now without fear of stiff penalties should you find that you miscalculated.

--It will be easier to convert all your old IRAs into one Roth and put new contributions there as well. That eliminates any fees associated with multiple accounts.

--There will be only one five-year holding period before you become eligible for withdrawals. It would begin the year you open your first Roth and apply to all money added later. You still must be 59 1/2 or use the money for certain exceptions like the purchase of a first home. But money contributed several years after the Roth is established becomes available for withdrawal that much sooner.

The flexible Roth isn't just for retirement anymore. It's a great way to shelter your estate and finance a first home or even fund a college education. There are myriad ways to take advantage. But first you must have a Roth to draw upon, and that's why the changes mentioned above are so important. They encourage people already retired or with the highest eligible incomes to set up a Roth. Some, though, might need to "manage" their income for at least one tax year to get it low enough to allow conversion.

Start with estate planning. By converting an old IRA to a Roth, you must pay some immediate tax, but you do not have to start withdrawing money after age 70 1/2, as with an old IRA. So you can let it keep growing tax free as long as you live. It might even pay for your heirs to pick up the tax bill on the conversion, if they can afford it and you can't. The savings are that dramatic over long periods of time.

Saving for a first home? As long as you've held a Roth for five years, you can withdraw as much as $10,000 penalty free and tax free at any age to make such a purchase. Early withdrawal is permitted for education too, but the investment gains are taxed. Still, if you are an older parent or a grandparent, you can use Roth withdrawals to pay for college, and it does not diminish your ability to make gifts of up to $10,000 per person per year.

I think parents and grandparents should consider funding a Roth for youngsters as soon as the kids have earned income from cutting grass or baby sitting. Socking away $2,000 a year (that's the max, and you can't exceed earned income) for even a few early years creates a versatile pool that may forever ease the pressure of a young person's costs for education, a first home and maybe even retirement.

See time.com/personal for more on IRAs. E-mail Dan at [email protected] And see him on CNNfn at 12:40 p.m. E.T., Tuesdays.