Is Roth IRA Right for You?

Roth IRAs (named after late U.S. Senator William Roth of Delaware who first proposed them in 1989) have been in existence since the Taxpayer Relief Act of 1997. In contrast to Traditional IRAs, contributions to the Roth IRA are not tax deductible but withdrawals are tax-free if certain conditions are met.

If we lived in a world where nothing changed, Traditional IRAs and Roth IRAs would in theory produce identical after-tax result for a taxpayer. For example, if taxpayers A and B (both 40 years old and both in the 25% marginal tax bracket) each contributed $5,000 today but A used Traditional IRA and B used Roth IRA, they would end up with identical net proceeds when they retire.

Obviously, the result changes when circumstances change. If we expect lower marginal tax rate in retirement than during working years, we should use Traditional IRA to maximize our tax savings. Taxation of social security benefits tends to complicate our tax projection and favors Roth IRAs. Since distributions from Roth IRAs are normally tax-free, they do not increase AGI and less of the social security benefits will be subject to tax. In other words, for retirees with limited “non-IRA income” and healthy social security benefits, Roth IRAs may be the better choice. Medicare Part B premiums are partially based on adjusted gross income as well, so no taxable income from IRA distributions can help in keeping the premiums low.

Taxpayers with limited or modest income sometimes hesitate to contribute to an IRA because they worry they may need the money before retirement. For those taxpayers, I would recommend contributing into a Roth IRA as they can withdraw their contributions at any time without tax or penalty. Many taxpayers are not aware of this rule and fail to utilize IRAs as their retirement savings vehicle. Some taxpayers with lower income can even obtain a retirement savings tax credit, which can range from 10% to 50% of the amounts contributed. Since IRA contributions for any given tax year can be made until April 15th of the following year, a tax professional can assist in figuring out the current tax benefit of the contribution prior to filing of the tax return.

Roth IRAs also have a couple of additional features that Traditional IRAs lack: 1) there are no required minimum distributions, so no money needs to be withdrawn when you reach 70 1/2 years of age; 2) contributions can be made even past the age of 70 1/2 if the taxpayer otherwise qualifies. Also, Roth IRAs are attractive assets to leave as an inheritance as it will not be subjected to income tax and even non-spouse beneficiaries can stretch withdrawals over their life expectancies.

Prior to 2010, there was a limitation on Roth IRA conversions if the taxpayer's income was too high. Since that time, however, anyone can convert Traditional IRA into Roth. This may be a particularly beneficial tool for business owners whose income often fluctuates from very high to very low and sometimes even negative. Conversion to Roth IRA in the years of extremely low or no income can prevent tax deductions from being wasted and a potentially significant amount of money can be sheltered from future taxation at no or very low current tax cost.

So is the Roth IRA the right choice for you? I believe that it is a good idea to have a Roth IRA in your "tax portfolio" because of its flexible features and planning opportunities it offers.

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