Every now and again, I write a piece knowing that there will be a backlash of some sort. This is one of those pieces.
You’d think something like a retirement plan would be easy, with little to no controversy. But since its inception under the Taxpayer Relief Act of 1997, the Roth IRA has drawn a mixture of accolades and criticisms. And practically, without fail, whenever I’ve written anything less than a full on embrace of the Roth, I’ve received a barrage of emails and comments telling me how very foolish I am for suggesting that you take a moment to (gasp) consider whether a Roth IRA is the best option for you rather than simply sign up. But I’m going to do it again anyway…
The Roth IRA is a retirement plan named after Senator William Roth (D-DE), who was the bill’s chief sponsor. The Roth IRA differs from a traditional IRA in that you pay the tax on the money going into the retirement account where it then grows tax free – when you take it out, you don’t pay federal income tax on the distributions. In a traditional IRA, you defer the federal income tax on the money going into the retirement account – when you take it out, you pay tax on the distributions.
A lot of folks (especially in the investment world) feel that you don’t need to look any further. They say: Tax free growth? Always a win! Thus, everyone needs a Roth.
Um, not so fast.
Yes, in theory, the potential for tax savings with a Roth is impressive. But as a good friend of mine is fond of saying, “But we don’t live in theory.”
There are a few circumstances when contributing to a Roth deserves some thoughtfulness:
- You’re looking for a tax deduction. Contributions to a traditional IRA may be eligible for an immediate federal income tax deduction while contributions to a Roth IRA are not eligible for a tax deduction.
- You’re expecting to be in a considerably lesser tax bracket when you will withdraw your IRA funds. One of the most appealing aspects of the Roth is the ability to make withdrawals tax free. But it’s important to consider the time value of money… If you pay tax at 35% now to not pay 10% in, say, five years, is it worth it? You have to bet on the fact that your money will grow fast enough to make up the difference. Consider the length of time of the investment and your respective tax brackets now and at retirement.
- You anticipate needing your IRA funds. One of the advantages of the Roth is that you are not required to make required minimum distributions (RMDs) at age 70-1/2 as you are required to do for a traditional IRA. If you don’t need the money, this can be a terrific estate planning technique since you can pass the money to your beneficiaries with a federal income tax savings. However, if you anticipate using the funds, the savings might not be as dramatic, depending on your circumstances (see #2 above).
Next, consider the mechanics. Even though the Roth has been around for awhile, it’s been modified a couple of times. In particular, for 2010 and 2011, the following rules and restrictions are important.
For 2010, your Roth IRA contribution limit begins to phase out if:
- Your filing status is married filing jointly or qualifying widow(er) and your MAGI is at least $167,000 (you cannot make a Roth IRA contribution if your MAGI, or modified adjusted gross income, is $177,000 or more).
- Your filing status is single, head of household, or married filing separate and you did not live with your spouse at any time in 2010 and your MAGI is at least $105,000 (you cannot make a Roth IRA contribution if your MAGI is $120,000 or more).
- Your filing status is married filing separate and you lived with your spouse at any time during the year (you cannot make a Roth IRA contribution if your MAGI is $10,000 or more).
For 2011, your Roth IRA contribution begins to phase out if:
- Your filing status is married filing jointly or qualifying widow(er) and your MAGI is at least $169,000 (you cannot make a Roth IRA contribution if your MAGI is $179,000 or more).
- Your filing status is single, head of household, or married filing separate and you did not live with your spouse at any time in 2010 and your MAGI is at least $107,000 (you cannot make a Roth IRA contribution if your MAGI is $122,000 or more).
- Your filing status is married filing separate and you lived with your spouse at any time during the year (you cannot make a Roth IRA contribution if your MAGI is $10,000 or more).
So long as you’re not phased out (see those AGI limits above), if you only make contributions to a Roth IRA, your contribution limit generally is the lesser of $5,000 ($6,000 if you are age 50 or older), or your taxable compensation.
It’s also important to remember that, for 2010, the MAGI and filing status requirements for converting a traditional IRA or rolling over an employer plan to a Roth IRA were eliminated. If you made a conversion or rollover to a Roth in 2010, you can choose to include the amount in income for 2010 or include the income in equal amounts in 2011 and 2012.
Other details to keep in mind… There’s no age limit and no time limit for contributing to a Roth IRA. You have to designate your IRA as a Roth IRA when you open the IRA. And since you don’t get a deduction for your contribution, you do not report Roth IRA contributions on your federal income tax return.
Obviously, there’s a lot here to consider (and clearly, some info I had to leave out). I highly recommend chatting with your financial advisor or your tax pro – or both – to see what works best for you. Which I guess leads me back to my point in the first place: think about it before you act. A Roth IRA can be a great choice for many taxpayers but it’s not a one size fits all fix (and emailing me won’t change my mind, just saying).
There are actually a few circumstances when Roth really does make sense. First, when income is above the traditional Ira phaseout. no reason not to do it then. Next, when you have a year with unusually low income, usually in 25% bracket, but this year at 15? convert just enough at 15 to top off that bracket. Last, for the retiree who will face increasin RMDs on her traditional Ira. This may throw her into the next bracket which she may want to avoid. I just finished the return for an 84 year old woman. For the last 6 years, we convert just enough to fill her 15% bracket but no more. Over time, her RMDs are increasing as a percent but the dollars aren’t rising as we keep moving money out. When she passes, her working children will avoid any tax on the Roth money.
One neat thing about the Roth is that the intial contribution dollars remain liquid at all times, since withdrawals are considered to be of basis dollars and not earnings on a FIFO basis.
Great post! I was just talking to my financial guy about this and telling him that I didn’t “get” all the hoopla about the Roth. When I’m retired, I’ll be in a lower bracket. Plus, If I get the tax benefit NOW, I can save more–the whole time value of money issue. If I save more over the next 20 or so years, I’ll have more for retirement and it will more than offset the tax I’ll have to pay at the lower rate. Glad you wrote this post. I have though about this for years, but just never got validation from anyone on this issue.
Thanks Russ, glad I could help!
Does anyone know if the MAGI requirements for converting a traditional IRA to a Roth have been re-instated for 2011? Or can anyone convert a traditional IRA to a Roth this year, as was the case last year?
Anne, the cap for conversions, I believe, has been changed permanently (I’m not 100% on that). I think the only real difference from 2010 to 2011 in that regard is the ability to spread out the tax (you can’t spread it out for 2011). I’ll try to confirm.
VERY good points. My clients constantly ask me about the pros and cons of IRAs and Roth IRAs. And it’s not always cut and dry as you point out…
Thanks California Trust Attorney!
In “The Gospel of Roth- The Good News About Roth IRA Conversions and How They Can Make You Money” by John Bledsoe it clearly states in the book that NO ANALYSIS is needed and that everyone should convert to a Roth IRA regardless of income. There is NO risk! The IRS is giving us a year to recharacterize or “undo” the conversion. This book gives the ins and outs for Roth IRAS! It really helped answer all my questions.
Current law says no income cap on conversion is ongoing. The 2010 split over two years was a one-shot.
Thanks JoeTaxpayer, that’s what I thought. I appreciate the confirmation.
I’m so glad you wrote this. I am a tax pro and I read so much bad advice on this subject from otherwise very informed financial bloggers. It is yet one more area where hiring an informed preparer can save you far more money than you spend.
If my wife and I make less than $160,000 combined in 2010, my understanding is that we can each contribute $5000 to our own Roth IRA’s if we’re filing jointly. Does the joint filing requirment apply only to our Federal tax return — we save approx $500 on our state tax return (Dist Columbia) if we file the state return as Married Filing Separately.
Thanks!