IRAs vs. Roth IRAs: Which to Choose?

The Roth IRA is a particular type of Individual Retirement Account (IRA) that takes its name from its legislative sponsor, the late Sen. William Roth (R-Del.). The Roth IRA differs in important ways from a traditional IRA. Either type of IRA might be chosen by the investor, depending on circumstances.

Details of the Roth IRA

The Roth IRA was contained in legislation enacted in 1997. It may contain securities of virtually all types, as well as real estate.

In order to contribute to a Roth IRA, eligibility criteria must be met. As with a traditional IRA, the contributor must have earned income and there are limits on annual contributions. The Roth-IRA contribution limits were steadily increased from the original 1998 limit of $2,000. For 2008-10, the limit is $5,000 for a single individual of age 49 or below and $6,000 for a single individual of age 50 or higher. This contribution limit applies to individuals with modified adjusted gross incomes (MAGI) of $105,000 or lower. Individuals with MAGIs between $105,000 and $120,000 can contribute a flat amount of $200. For 2010, these maximum income levels were lifted, allowing individuals to contribute the maximum amount regardless of income.

The key features of the Roth IRA relate to the tax status of contributions. Unlike the traditional IRA, the Roth IRA offers no tax deduction for current contributions, withdrawals (after age 59 ½) can be made tax-free, and there are no required minimum distributions during retirement from the Roth IRA. Like the traditional IRA, investment gains inside the Roth IRA accrue tax-free.

Holders of traditional IRAs have the privilege of converting them to Roth IRAs by paying tax on the proceeds of the conversion at ordinary-income rates prevailing in the year of conversion. Subsequent withdrawals of principal from the Roth-Conversion IRA can be made tax free after a “seasoning period” of five years. The growth portion of the Roth-Conversion IRA can be withdrawn tax-free after expiration of the seasoning period, provided the taxpayer is older than age 59 ½.

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Advantages of Roth IRA vs. Traditional IRA

Among the advantages of the Roth IRA vs. the traditional IRA are the following:

  • Harder to deplete – The absence of minimum required distributions and taxation in retirement allows Roth IRA contributions to remain intact and investment compounding to continue for a longer period, thus making it harder (all other things equal) to deplete the proceeds and run out of retirement wealth.
  • Better for Heirs – Heirs of the Roth-IRA holder can not only inherit Roth IRA funds, but also withdraw them tax-free. In contrast, inheritors of a traditional IRA would pay ordinary-income tax upon withdrawals from it.
  • Better for Surviving Spouse – A surviving spouse can inherit a Roth IRA and combine it with his or her own Roth IRA without penalty, which may not be true of a traditional IRA.
  • Conversion Privilege – A traditional IRA can be converted to a Roth IRA, possibly to the taxpayer’s advantage.
  • First-time Home-buying Withdrawal Privilege – Up to $10,000 in Roth IRA proceeds can be withdrawn for the benefit of a first-time home buyer. The home-buyer may be the taxpayer, spouse, or direct descendant or ancestor of the home-buyer. The home-buyer must not have owned a home for the previous 24 months.
  • Better Fit With Other Tax-Advantaged Plans – Roth IRA contributions are unaffected by possession of other tax-advantaged accounts, such as a 410(k) plan. In contrast, possession of another tax-advantaged account may eliminate the tax-deductibility of traditional-IRA contributions.
  • Conversion for Estate-Tax Purposes – Conversion to a Roth IRA can reduce the value of an estate. Since taxes have already been paid on the Roth IRA, its proceeds are not subject to estate taxation, which may reduce the estate’s value sufficiently to keep it under the $3.5 million estate-tax threshold.
  • Possibility of Reducing Tax Rate – Taxes must be paid at some point on contributions to either a traditional IRA or a Roth IRA; the difference is the timing of tax payments. If the current tax rate paid on Roth IRA contributions is less than the future rate that would otherwise be paid on traditional IRA withdrawals, the taxpayer may benefit from choosing the Roth IRA. Warning: This is a tricky comparison, since the Roth IRA contributor is, in effect, making a smaller after-tax contribution than a traditional IRA contributor from the same before-tax dollars. That means the Roth IRA contributor is foregoing the additional tax-free growth that could have been realized from a traditional IRA contribution.

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Advantages of Traditional IRA vs. Roth IRA

Among the advantages of the traditional IRA vs. the Roth IRA are the following:

  • Immediate Tax Savings – Traditional IRA contributions are tax-deductible, creating a tax benefit equal to the contribution amount multiplied by the taxpayer’s marginal tax rate (expressed as a decimal). This is the other side of the tax coin, since it is withdrawals from the Roth IRA that receive the tax benefit.
  • High Earners Probably Pay at a Lower Effective Tax Rate – For comparison purposes, a key question is: Which is lower – the taxpayer’s current marginal rate or the future marginal rate at the time withdrawals are taken? Current high earners, who are in the highest marginal tax bracket, stand a good chance of being in a lower marginal tax bracket in retirement. In other words, the tax rate they avoid by contributing to a traditional IRA is higher than the one they will face in the future if they choose a Roth IRA. This should tip the scales in favor of the traditional IRA. In general, the higher the current marginal tax rate, the more likely is the traditional IRA to be the best choice.
  • Reduction of Adjusted Gross Income May be Beneficial – Contributions to a traditional IRA (and other tax-advantaged plans such as 401(k), 403(b), SEP and SIMPLE IRA) reduce the taxpayer’s adjusted gross income (AGI), whereas Roth IRA contributions do not. AGI reduction may be beneficial if it is necessary to make the taxpayer eligible for tax deductions or credits, such as the earned-income credit or the child tax credit.
  • Shorter-lived People Probably Gain – The traditional IRA offers an immediate gain (the tax deduction) compared to the eventual gain of the Roth IRA. Some people will not live to enjoy most or all of the Roth IRA gain. Such people are better off with the traditional IRA. The fact that the Roth IRA is usually the withdrawal choice of last resort reinforces this point.
  • Possibility of Saving on State Income Taxes – Roth IRA contributors are liable for state income taxes on their contributions. A way of saving on state income taxes would be to choose the traditional IRA, then retire to a state with low (or no) state income-tax rates. This is a not-unlikely scenario, since low-tax states are often desirable retirement destinations as well.

Conversion of a Traditional IRA to a Roth IRA

It is possible to convert a traditional IRA to a Roth IRA by paying the taxes due on the proceeds in the year of conversion. Prior to 2010, only taxpayers with incomes below $100,000 could make such a conversion. In 2010, this income limitation was lifted. In addition, taxes on 2010 conversions can be delayed until the 2011 tax year and split between tax years 2011 and 2012.

For the most part, the pros and cons of an original choice between traditional IRA and Roth IRA also apply to a Roth IRA conversion. There are a few situations, such as estate-tax minimization, that are relevant to the conversion only.

Weighing the Balance – Traditional IRA vs. Roth IRA The possible points of comparison between the traditional IRA and the Roth IRA are so many that an educated choice may well require the assistance of a financial-planning professional. In particular, the issue may well turn on the key point – what marginal tax rate will the taxpayer face at, and during, retirement, compared to his or her current marginal tax rate? Unfortunately, even when the answer might otherwise seem clear, political considerations affecting future tax rates may still cloud the issue.

It is not even clear how to decide close cases. The taxpayer might allow the avoided hassle of dealing with minimum required distributions and associated paperwork to tip the balance in favor of the Roth IRA. Alternatively, it might be just as reasonable to allow the possibility of early death to sway the decision in favor of the traditional IRA.

A sensible procedure would be to make several sample calculations under different assumptions about future tax rates. For example, the taxpayer might assume, first, that the marginal tax rate will remain the same in retirement. The next calculation might be made assuming that the retirement tax rate is one bracket higher, and so forth. The results of these hypothetical scenarios may make the decision obvious.

The foregoing may seem overly nuanced in view of the current stampede to convert traditional IRAs to Roth IRAs. That trend is almost certainly driven by two considerations – the relaxation of the income ceiling for Roth IRA conversions and a political judgment that future tax increases are a foregone conclusion. History suggests, however, that making political predictions is roughly as difficult as predicting investment returns of different assets. Doing the hard work of making sample calculations is likely to pay off if for no other reason than that the taxpayer will have the satisfaction of knowing that he or she pulled out all the financial-planning stops.

A Mixed Strategy – Annuity Plus Roth IRA

One of the biggest advantages of a Roth IRA is the fact that it is harder to deplete. This reduces “longevity risk,” the danger of running out of money before death. This implies that withdrawals from the Roth IRA will be delayed as long as possible to allow investment gains and compounding to create the maximum amount of retirement wealth. The best way to execute this strategy is to draw upon alternative retirement-income sources for basic expenses, such as food and shelter, thus allowing the Roth IRA to remain intact as long as possible.

An attractive complement to the Roth IRA is a life annuity with a payout designed to cover likely expenses in retirement. This allows use of the Roth IRA to bolster the retiree’s standard of living and hedge against the possibility of inflation. The recent availability in America of real (inflation-adjusted) annuities is a possible supplement to this strategy.

Summary

The Roth IRA is an intriguing and potentially beneficial alternative to the traditional IRA. The Roth IRA reverses the timing of its tax benefit, compared to the traditional IRA, by placing tax payment up front and eliminating ordinary-income tax payment in retirement. The Roth IRA also eliminates the hassle and disadvantage of minimum required retirement distributions. The Roth IRA is almost certainly preferable when legacy is a paramount consideration, since it relieves heirs of taxation on the inherited proceeds.

Both retirement-account choices have various advantages that make a clear-cut recommendation difficult. The number and complexity of these comparison points argues in favor of carefully planning the choice.

A promising retirement strategy is to combine an annuity with a Roth IRA. By covering basic expenses, the annuity frees the Roth IRA to perform the core function of overcoming longevity risk and protecting the retiree’s standard of living.

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