Is a Roth IRA Right for You?

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Is a Roth IRA Right for You?
by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
November 29, 2007

Reprinted from the November 2007 issue of Schwab Investing Insights®, a monthly publication for Schwab clients.

When it comes to retirement savings, the Roth IRA offers unique retirement-savings benefits. First introduced in 1998, it provides no tax deduction for contributions, but your investments can grow tax-free and withdrawals are tax-free. In addition to gaining key estate-planning benefits, you can avoid early distribution penalties on certain withdrawals, and there's no need to take minimum distributions once you reach age 70½.

Until recently, however, most upper-income Americans weren't eligible to take advantage of all that Roth IRAs have to offer. Fortunately, recent rule changes have made them more widely available, and other changes are coming in the next few years that you may be able to use to your advantage. (If you're already familiar with Roth basics, you can skip to "Conversions get easier for affluent seniors.")

Roth IRA vs. traditional IRA
This year, for the first time, the modified adjusted gross income (gross income from all sources, increased or decreased by certain adjustments—see IRS Publication 590 for details) limit for Roth IRA eligibility increased for inflation. If you're single, your ability to contribute to a Roth phases out between $99,000 and $114,000 and for married filing jointly, between $156,000 and $166,000.

Money put into a traditional IRA is generally tax-deductible, unless you're an active participant in a qualified employer plan like a 401(k). In that case, for 2007, your traditional IRA contribution is fully deductible if your modified adjusted gross income is $52,000 or below and you're a single filer (phasing out up to $62,000). If you're married filing jointly, it phases out between $83,000 and $103,000 (and between $156,000 and $166,000 for the nonparticipant spouse of an active plan participant when filing jointly).

Nondeductible traditional IRA
Given current tax law—particularly, low long-term capital gain and qualified dividend rates—a nondeductible contribution to a traditional IRA rarely makes sense. There's no up-front deduction, and earnings are taxed at higher ordinary rates when withdrawn. With a deductible traditional IRA, distributions are taxed at ordinary rates, but you receive an up-front deduction.

With a Roth IRA, there's no deduction, but earnings can be withdrawn income-tax-free if you're at least 59½ and have had the Roth at least five years. And you don't need to take required distributions at any age, as you do with a traditional IRA after age 70½.

So if you do qualify for a deductible traditional and a Roth IRA, which one makes the most sense? Of course, everyone's situation is unique, but here are some generally applicable rules of thumb to help you choose wisely:

If you think your tax bracket will be higher when you retire than it is today, a Roth IRA probably makes sense—especially if you're a younger worker who's yet to reach your peak earning years. In the "Compare: Roth vs. Traditional IRA" table, you can see that the Roth is better when your marginal rate at the time of withdrawal is the same or higher compared with your marginal rate at the time of the initial contribution.

If you think your tax bracket will be much lower when you retire, you may be better off taking the up-front deduction of a traditional IRA. In "Compare: Roth vs. Traditional IRA," you can see that your marginal rate at the time of withdrawal would need to be about 5% less than a current assumed rate of 25% for a deductible traditional IRA to be the better option, all else being equal.
If you think your tax bracket will be the same when you retire, it's almost a wash for income tax purposes. But with a Roth, you aren't subject to minimum distributions, and if you leave a Roth behind when you die, your heirs can stretch out their own income-tax-free distributions.

Another advantage of a Roth is that contributions may be withdrawn anytime for any purpose without tax or penalty. However, just because you can do this doesn't mean you should. Taking it out early carries hefty opportunity costs because you'll have that much less working over time toward your retirement. You can put in only $4,000 a year for 2007 (climbing to $5,000 in 2008), plus $1,000 if you're 50 or older, so taking out previous contributions may be hard—or even impossible—to make up.

Roth IRA conversions: potential tax and estate-planning benefits
Another way to take advantage of a Roth IRA's potential benefits is to convert a traditional IRA to a Roth. Under current law, eligibility to perform a Roth conversion has an income cap—for most taxpayers, modified adjusted gross income must be $100,000 or less in the year of conversion. The good news is, the converted IRA balance doesn't count for purposes of the $100,000 test, though it is included as part of your taxable income. You must pay the income tax in the year you make the conversion. But that could make sense if you expect to be in a higher bracket down the road, have a long-term time horizon and can pay the income tax from other funds.

Aside from potential income tax benefits, however, converting part or all of a traditional IRA to a Roth could be advantageous as an estate-planning strategy if you have significant IRA balances you don't plan to tap during your lifetime. Though the value of a Roth will still be included in your gross estate, because there are no required minimum distributions, the account could grow larger than it otherwise might under traditional distribution rules—leaving more for your heirs. Also, your beneficiaries can make income-tax-free withdrawals during their lifetimes.

What's more, income tax you pay on conversion (preferably from assets other than the IRA) will reduce your gross estate. In effect, you're prepaying income tax on behalf of future beneficiaries without it really counting as a taxable gift. This could be particularly beneficial when there's little or no taxable estate to speak of anyway, because in such cases, there'd be no future tax deduction available to beneficiaries for previously paid estate taxes.

Conversions get easier for affluent seniors
As of 2005, if you're 70½ or older, you no longer must include required minimum distributions from a traditional IRA when calculating the $100,000 income test for conversion (distributions are still taxable, of course). This allows more affluent seniors to take advantage of Roth conversions for estate-planning purposes.

Imagine a 71-year-old female with a $2 million traditional IRA balance who earned $25,000 in taxable interest and dividends, received $36,000 from Social Security and took a traditional IRA distribution of $73,000. In her case, 85% of Social Security benefits are taxable. Adding $30,600 to the other figures brings adjusted gross income to $128,600 for tax purposes. However, subtracting the $73,000 required minimum distribution leaves $55,600 for eligibility purposes—well below the $100,000 conversion threshold.

Without the 2005 law change, she'd have been ineligible for a Roth IRA conversion, but because her traditional IRA distribution isn't included in the eligibility test, she qualifies. The minimum distribution would still be required in the year of conversion, but going forward, she would have no forced withdrawals from the new Roth IRA.

Roth 401(k)s: particularly appealing for younger workers
If your employer offers the Roth 401(k) (not all do—it was just introduced in 2006), it works much like a Roth IRA: Contributions come from after-tax dollars (no up-front deduction), and qualified withdrawals are free from income tax. One big difference is there are no income limits to participate, and the contribution limit of $15,500 per person (plus an additional $5,000 catch-up contribution if you're 50 or older) is much higher than the Roth IRA limit.

Additionally, you can roll over the balance from a Roth 401(k) into a regular Roth IRA. According to the rules, any employer match would automatically go into a separate traditional 401(k) account, regardless of where your contributions are directed. The choice of a Roth 401(k) could make sense if you think your tax bracket will be the same or higher in retirement. That might not be a bad guess if you expect to generate lots of portfolio income and anticipate hefty retirement distributions. Also, there's the risk that currently low marginal federal tax brackets might be raised to deal with looming federal budget and entitlement program deficits.

As with a Roth IRA, the Roth 401(k) could be especially attractive if you're young and have yet to reach your peak earning years. Whatever your situation, if your employer offers both types of 401(k)s, you can stay flexible by splitting contributions between the traditional and Roth options. That way, your retirement income will be further diversified between taxable and nontaxable buckets.

Qualified rollovers made easier next year
Starting in 2008, you can directly convert a traditional 401(k) into a Roth IRA without having to roll it into a traditional IRA first—say, if you change jobs. However, you must pay federal income tax on pretax contributions and earnings, and Roth conversion eligibility requirements still apply. So if you earn more than $100,000 in modified adjusted gross income, you won't be eligible to roll your funds—until 2010, when the $100,000 rule is set to expire.

Roth IRA conversions made easier for everyone in 2010
If you're currently ineligible for a Roth IRA, you might consider maximizing contributions to a traditional IRA so you can convert to a Roth in 2010. In fact, there's a special rule in place only for 2010 that will allow you to recognize conversion income in 2010 or split it between the next two years. However, before taking this course, consider these caveats:

You can't pick and choose which portion of traditional IRA money is converted. The IRS looks at all traditional IRAs as one when it comes to distributions (including Roth conversions). Traditional IRA balances are aggregated so that the amount converted consists of a prorated portion of taxable and nontaxable money. So making nondeductible contributions to a traditional IRA within the next few years in anticipation of the 2010 limitation repeal would likely work best if you have little or no existing deductible IRA balance to muddy the waters. Still, any earnings in the years leading up to conversion would be subject to income tax (which, as always, is best paid from outside funds).

According to current law, starting in 2010, high earners otherwise not eligible to make Roth contributions could make nondeductible contributions to a traditional IRA and then convert to a Roth the next day with no tax consequence whatsoever. This could be repeated every year, circumventing Roth income limits on contributions. If this is what Congress intended, it would have just eliminated Roth contribution limits along with the conversion limit, so don't be surprised if Congress writes some sort of anti-abuse provision into the law prior to 2010.

The bottom line
A Roth IRA can be a great long-term savings tool, so try to take advantage of these rule changes if you can. Just remember that tax laws are subject to change, so stay current at www.irs.gov. Also, be sure to talk with your accountant or other professional tax advisor about whether a Roth IRA makes sense for you.

Important Disclosures

1. Another way to compare a traditional deductible IRA and a Roth IRA would be to assume that only $3,750 would be invested in the Roth ($5,000 minus $1,250 in taxes paid today). In that case, if marginal tax rates then and now were the same, ending after-tax balances would be identical at $25,682. For illustration purposes, however, we assume the full $5,000 would be invested in both types of accounts. To make it a fair comparison, we account for the fact that the $1,250 up-front tax savings could have been invested in a taxable account. In cases where the tax savings are not invested (i.e., when they are spent), a lower opportunity cost might be justified, which would make the Roth look even better by comparison.
2. Assumptions: The lump-sum withdrawal (liquidation) after 25 years will be taxed at individual income tax rates of 30%, 25% or 20% for the traditional deductible and nondeductible IRA; it will be tax-free for the Roth IRA. Long-term appreciation is taxed at the 15% long-term capital gains rate for the taxable account.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should pursue any particular investment security. All expressions of opinion are subject to change without notice as a result of shifting market conditions. Past results are not indicative of future performance.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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