Let’s simplify this issue.
The determination as to which retirement account investors should fund, or convert to, is ultimately based on two factors: taxes and withdrawals. Investing is about total return, into which taxes play a significant role. A Roth IRA is funded with after-tax dollars, grows tax-free, and is withdrawn from tax-free. The rules for the tax-free, penalty-free, distributions require that the money was in the account for at least 5 years and the investor is at least 59½ years old. The contributions (not the gains) can be withdrawn from a Roth at any time, without tax or penalty.
A Traditional IRA is typically funded with pre-tax dollars and rollovers from pre-tax employer retirement plans, such as 401k and 403b plans. (Some investors do fund their Traditional IRAs with after-tax dollars.) The account grows tax-deferred (no taxes are assessed on the gains or income until distribution). When the investor begins taking distributions, all of the distributions…both the invested capital and the gains, are taxed as ordinary income at the taxpayer’s rate at the time of the withdrawals.
As you can see, the government gets paid; it’s only a matter of whether the payment is upfront (Roth IRA) or at the back-end (Traditional IRA). As investors, we get to decide when Uncle Sam gets his cut. Ideally, he gets the smallest cut possible. The goal is to pay the taxes on the invested funds while in a lower tax bracket. The lower tax bracket may be a result of a low income year or a year with lots of deductions. What we don’t know is the future of tax rates.
For younger workers, using a Roth to save for retirement is a wise decision as they are likely in a lower tax bracket today than they will be in retirement. A low income, high deductions year can also be a good time to convert some or all of a Traditional IRA to a Roth IRA in order to pay Uncle Sam at a lower rate. As taxpayers, we have until October 15th of the year after we make the Roth conversion to change our minds. It’s called recharacterization. The goal is to pay the tax at the lowest rate and at the lowest account value. If you convert to a Roth in July of 2014 and by July of 2015 the account value has dropped, you can hit the “undo” button and the converted funds will revert back to the Traditional IRA. This allows the investor the opportunity to pay taxes on the conversion when the account is at a lower value. Lower taxes times lower account value translates into a smaller cut to the government. If you convert, you’ll need to have non-IRA funds available in order to pay the taxes. The opportunity cost on the money used to pay the taxes will depend on how those funds were previously invested.
On to withdrawals. If you own a Traditional IRA, the government requires you to begin taking mandatory distributions at least annually, beginning no later than April 1st of the year after you turn 70½. The amount of the withdrawal is based on the value of the account, the owner’s age, and the age of account owner’s spouse (if married). Whether you need the money or not, you must withdraw it…otherwise Uncle Sam slaps you with a 50% penalty on the amount that should have been withdrawn. Ouch! You pay ordinary income tax on the withdrawn amount, at whatever tax rate you’re in at the time. Keep in mind that most folks are also receiving Social Security benefits at that age, which when combined with the IRA withdrawals may push them into a higher tax bracket. With the Roth IRA, distributions on the part of the original account owner are not only tax-free but they are also entirely voluntary. There is no mandated minimum withdrawal amount or time frame. Distributions from a Roth are not required unless or until the account is passed on to a beneficiary at the original account owner’s death.
To tie it all together. Use a Roth or Traditional IRA to manage the tax and the withdrawals. If you are in a high tax bracket now but expect to be in a lower bracket in retirement, use a Traditional IRA and don’t convert to a Roth. If you are in a low tax bracket now but expect to be in a higher tax bracket in retirement, pay the tax upfront with a Roth contribution or Roth conversion. Remember that you must take distributions from a Traditional IRA once you reached your early 70’s.
For more on the specific IRA rules, please visit http://www.irs.gov/Retirement-Plans/Traditional-and-Roth-IRAs.
Feel free to contact me if you want to talk about your retirement plans.