September 22, 1997

Q. What would be the best strategy for the new Roth IRA, in which the investor gets no tax benefit at the time of the contribution but all accumulated earnings can be withdrawn tax-free at retirement? As all the tax savings come at the end, I would hope for maximum earnings. Would an aggressive small-company growth fund be the best bet? But as capital gains from the growth fund would be taxed at a lower rate, would it be better to use the Roth IRA for an investment that produced high interest or other income that would be taxed at a higher rate?

M.T., Eugene, Ore.

A. I think you're a little confused. Once you put money into an IRA, whether it be a traditional IRA or the new Roth IRA available next year, there are no differentiations between interest or dividend income and capital gains.

With a traditional deductible IRA, all money is treated simply as earned income upon withdrawal. With a non-deductible IRA, all of the gains produced by the investment are treated as earned income upon withdrawal, but the original after-tax (or non-deductible) contributions are treated as a non-taxable return of capital.

With the new Roth IRA, the contributions are made with after-tax dollars, so the owner receives no current tax deduction. In return, the investor may eventually withdraw the funds -- and any earnings produced -- on a tax-free basis. Withdrawals may be made without penalties or tax after age 59 1/2, but only provided that the funds withdrawn have been in the account for at least five years. (Withdrawals before age 59 1/2 are tax-free provided the IRA has been held for five years and the owner dies, becomes disabled, or uses the proceeds, up to $10,000, for a first-time home purchase.) Other features of the Roth IRA that differ from traditional IRAs include no minimum distributions and contributions are allowed after age 70 1/2, provided the contributions come from earned income. The maximum annual contribution is $2,000, plus $2,000 for a spouse, but this threshold is reduced if your adjusted gross income exceeds $95,000 and disallowed entirely if it exceeds $110,000; for couples filing jointly, the comparable figures are $150,000 and $160,000. All of this information, and more, is available in an excellent pamphlet called ``Understanding the Taxpayer Relief Act of 1997,'' recently published by the Vanguard Group. This pamphlet covers all facets of the tax changes affecting investors, including changes in the capital gains tax, and a discussion of the education IRA.

Vanguard's analysis of the Roth IRA comes to this conclusion: People are better off with a Roth IRA than a traditional IRA ``so long as the tax rate in effect when the deduction is taken is not considerably higher than the tax rate in effect when withdrawals are taken.'' In short, it's a good tool for people who expect to remain in a high tax bracket in retirement, and the great majority of the populace, who expect significantly lower income -- and a lower tax bracket -- in retirement, should probably stick with the traditional IRA. Another class of likely Roth IRA investors would be people who expect tax rates in general to rise, so that even in retirement the levy will be heavier than it is now; the great feature of the Roth is that once the money is committed to it, the owner can forget about taxes entirely, so far as that money is concerned.

So what would be the best investment for a Roth IRA? Since there are no differentiations between capital gains and other earnings, the investment should fill the same requirements as any IRA investment -- likely to produce the highest potential returns commensurate with the owner's appetite for risk. That said, if I had both traditional IRA and Roth IRA portfolios, my inclination would be to hold the more aggressive assets in the Roth, while maintaining the more conservative end of the portfolio in the traditional IRA. This is clearly an optimist's strategy -- if my aggressive investments do well, I would enjoy large gains that are entirely sheltered from taxes; similarly the more modest gains from the conservative holdings in the traditional IRA would be smaller, and thus would engender a smaller tax bite upon withdrawal. But if I have bad luck or am a lousy stock-picker or a bad fund-picker, the tables turn -- I will have paid taxes up front to enjoy the shelter of the Roth IRA, only to find very little being sheltered, and the conservative investments that were in the traditional IRA will still attract the attention of the taxman.