Roth IRAs: Maybe Time for a Fresh Look

rothWith the 2013 income tax rates now settled, it’s a good time to review the advisability of Roth vs. traditional IRAs. As you know, Uncle Sam gets his tax money either way. You pay a smaller amount earlier with Roth accounts or a larger amount later with traditional IRAs. 

Your expected rate of income tax in retirement is key. If you think you’ll be in a lower tax bracket when you retire, then a traditional IRA might be best. With a traditional IRA, you get the upfront deduction at current tax rates and pay tax on the IRA at lower rates as you withdraw the money. If, on the other hand, it is likely that your tax rate at retirement would be equal to or more than your current income tax rates, then Roths should be considered. With a Roth, withdrawals in retirement are generally tax-free and there is no required minimum distribution for you or your spouse at age 70 ½. Furthermore, by paying the tax now, you have locked in the tax rate on the IRA, regardless of future tax rate changes by Congress.

Generally, you can establish Roths three ways: 1) Roth IRA contributions, 2) on-going Roth contributions to a 401(k) or Roth 403(b) at work, or 3) a Roth conversion. Here are some specific situations where use of a Roth may be advisable.

  1. Young workers who are starting their career and have current low income tax rates. If you have sufficient earned income, you can still invest $5,000 for 2012 and $5,500 for 2013 into a Roth or a traditional IRA. As an example, if a young person invested $5,500 in a Roth for 10 years and it grew for 30 years thereafter all at a 5% return, the Roth account 40 years from now would be $300,000, all tax-free. 
  2. Taxpayers who experience a low year in taxable income (for example, they might be between jobs), might consider a Roth conversion for a portion of their traditional IRAs. 
  3. Taxpayers, who expect that they will not need their IRA and 401k funds during their retirement and that their retirement income tax rates will be similar to their current rates, should consider a Roth conversion. By converting to Roth and paying the tax now, you are not forced to take withdrawals. Furthermore, when you and your spouse are gone, your children (and grandchildren) can continue to get the benefits of tax-free earnings, since they are only required to take distributions based on their life expectancies and can stretch the Roth for decades.
  4. Taxpayers who want to convert may consider doing an installment program. You would convert an appropriate amount each year, making sure that you don’t change your current income tax bracket. For example, for 2013, the 25% marginal income tax bracket for married couples applies to taxable incomes from $72,500 to $146,400. 

Most of you will be meeting with your CPAs in the next 6-7 weeks. It’s probably a good time to also get their input on Roths for you. Tell them that DWM, your proactive, fee-only financial planner, encouraged you to ask.