To Roth or Not to Roth
Lauren N. Desforge, CFP®, CPA/PFS, CDFA®, AEP®
Like many people, you’ve probably heard of the term “Roth,” but may not be sure what it is and whether you should have a Roth as part of your retirement savings strategy. In this article, we’ll highlight some reasons you may want to directly invest in a Roth or convert to a Roth.
Most people own a tax-deferred retirement plan such as a traditional IRA, 401(k) plan, or 403(b) plan. With these traditional plans, contributions are made with pre-tax dollars (you are not taxed on the income that you contribute) and the earnings within the plan grow tax-deferred until you take distributions. The IRS requires that distributions begin, generally, when you turn age 70 ½. Roth IRAs and Roth 401(k) plans were added as retirement savings plans in 1997 and 2006, respectively. Contributions to Roth plans are made with after-tax dollars (you are taxed on your income, thereby receiving no current tax benefit); however, the earnings in the Roth grow tax-free. Qualified distributions are tax-free, and the IRS does not impose any required minimum distributions on the owner or spouse.
Below is a comparison of the key rules for Traditional IRAs and Roth IRAs:
|Roth IRAs vs. Traditional IRAs||Traditional IRA||Roth IRA|
|Distributions required at age 70 ½||Yes||No|
|Annual contribution limits |
|$6,000 under age 50 |
$7,000 age 50 and over
|$6,000 under age 50 |
$7,000 age 50 and over
|2019 income limits – Single||$64,000-$74,000*||$122,000-$137,000|
|2019 income limits – Married Filing Jointly||$103,000-$123,000*||$193,000-$203,000|
*The income limits are waived on a Traditional IRA if the individual (and spouse, if married) does not qualify to contribute to an employer retirement plan.
Contributing to a Roth IRA or Not
Which is the better option—to contribute to a traditional IRA or a Roth IRA? The deductible IRA gives you a tax break now while the Roth IRA gives you a potentially larger tax break in the future. In theory, assuming the same tax rates now and in the future, both choices will result in the same wealth creation. The following example will highlight this concept:
You are in a 24% tax bracket and contribute $1,000 of your earnings to a deductible IRA. The $1,000 doubles in growth to $2,000. When you withdraw it, you will pay $480 in tax and have $1,520 to spend. If you decided instead to add to a Roth IRA and you want to factor in the $240 taxes ($1,000 * 24%) on your income, you will have $760 after-tax to invest. That $760 doubles in growth to $1,520. In both cases, you have $1,520 after tax—neither one produces more wealth.
Individuals who contribute to a Roth often have more wealth at retirement. This is because people who contribute to a deductible IRA usually do not save and invest their tax savings created by the IRA deduction; they spend it. Therefore, these individuals do not invest the same amount of money as those who contribute to a Roth IRA.
Roth contributions are a good choice for:
- Continued growth during the owner and spouse’s retirement years–no required minimum distributions are required at age 70 ½.
- Young workers who likely are in a lower tax bracket now than they will be in retirement.
- Individuals who want to pass tax-free money to their heirs—a Roth IRA can be a powerful tool for next generation wealth transfer.
- Distributions can be made over the beneficiaries’ lifetimes based on IRS tables, allowing most of the assets to continue to grow in the Roth tax-free for decades. Once the Roth IRA is transferred at death to a non-spouse, the rules require that beneficiaries start taking tax-free distributions beginning the following year.
- Caveat: the distributions may be partially taxable if they occur within 5 years of the Roth conversion.
Converting to a Roth or Not
Since January 1, 2010, all individuals, regardless of income levels, can convert existing traditional IRAs into Roth IRAs. While there are income limitations to contribute to a Roth, anyone can convert a traditional IRA to a Roth IRA. Should you convert? The answer is “it depends,” as there are several factors to consider:
Taxes are due on a conversion to a Roth. If you need to pay the taxes with money from your IRA, it is not a good idea to convert. If you have the cash to pay the taxes, it may be worth considering since current tax rates (as created by 2017 tax law and in effect through 2025) are low compared to historical and scheduled future rates.
Consideration must be given to how the additional taxable income will affect your tax return. If you are receiving Medicare, the Roth conversion could trigger a Medicare surcharge. The additional income recognized from a Roth conversion could also subject you to higher capital gains tax rates and the 3.8% net investment income tax on investment income. Every taxpayer situation is unique and must be analyzed carefully.
If your traditional IRA beneficiary is a/an:
- Account owner and they plan to spend down, the benefits of converting may be minimal.
- Charity – A conversion will not be optimal due to the tax hit on conversion.
- Owner’s descendants – A conversion could offer great potential benefit. It can be paid out over the descendants’ lifetimes (based on current tax law).
Back door Roth
A back door Roth involves contributing to a traditional non-deductible IRA (no income limits) and then converting to a Roth IRA. The rules require that you have earned income or be the non-working spouse whose spouse has earned income and you must be under age 70 ½ years old. Backdoor Roth IRAs can also be funded using after-tax contributions made to employee 401(k) plans, generally upon separation from service from the employer. A backdoor Roth can be a very powerful planning option for high-earning households whose income makes them ineligible to fund a contributory Roth IRA.
A Roth IRA may be a prudent choice to include in your retirement savings strategy. To Roth or not may not be an all or nothing decision.
Talk to your advisor to determine what strategy is best for you.