Is a Roth IRA Right for You?

Updated December 14, 2011

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

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 required minimum distributions (RMDs) once you reach age 70½.

Roth IRA vs. traditional IRA

Contribution limits: Roth IRA

If you're single, your ability to contribute to a Roth IRA for tax year 2011 phases out for modified adjusted gross incomes (MAGI) between $107,000 and $122,000. If you're married and filing jointly, contribution eligibility phases out between $169,000 and $179,000 MAGI. In 2012, the phase-out increases to $110,000–125,000 for single and $173,000–183,000 for married filing jointly.

Contribution limits: traditional IRA

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 2011, your traditional IRA contribution is fully deductible if you're a single filer and your MAGI is $56,000 or below (phasing out up to $66,000). If you're married filing jointly, it phases out between $90,000 and $110,000 (and between $169,000 and $179,000 for the nonparticipant spouse of an active plan participant when filing jointly). For 2012, the limits are $58,000–68,000, $92,000–112,000, and $173,000–183,000, respectively.

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 There's no up-front deduction, and earnings are taxed at higher ordinary rates when withdrawn.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.

So if you do qualify for a deductible traditional and a Roth IRA, how do you choose between them? Of course, everyone's situation is unique, but here are some generally applicable rules of thumb to help you make a decision:

• If you think your tax bracket will be higher when you retire than it is today, you should probably consider a Roth IRA—especially if you're a younger worker who's yet to reach your peak earning years. In the table below, 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.

Roth vs. traditional IRA

• 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 the table above, 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 IRA 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 $5,000 a year for 2011 and 2012, plus an additional $1,000 "catch-up" contribution if you're age 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. Prior to 2010, eligibility to perform a Roth IRA conversion had an income cap—for most taxpayers, MAGI had to be $100,000 or less in the year of conversion. However, beginning in 2010, the rules surrounding conversions of traditional IRA money to a Roth IRA changed. MAGI limitations are no longer in effect, meaning all investors are eligible to convert their traditional IRAs to Roth IRAs.

If you choose to convert, you must pay the income tax in the year you make the conversion. But that could still be a good option 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.

Roth 401(k)s: particularly appealing for younger workers

If your employer offers the Roth 401(k), 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 $16,500 per person (plus an additional $5,500 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

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.

Roth IRA conversions

If you're ineligible for a Roth IRA, you might consider maximizing contributions to a traditional IRA so you can convert to a Roth. 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 with the goal of later converting to a Roth IRA would likely work best if you have little or no existing deductible IRA balance to muddy the waters. Still, any earnings leading up to conversion would be subject to income tax (which, as always, is best paid from outside funds).
• As the law currently stands, 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 at some point.

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 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.

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.