To Roth or Not?

One common question we get from clients is whether Roth IRAs or Traditional IRAs are better.  Before I try to answer that, let’s get one thing out of the way- this isn’t tax advice and I’m not a tax advisor.  That being said, the answer (in my opinion), is that it really depends.


To start with, let’s clarify what makes a  Roth IRA (RIRA) different from a Traditional IRA (TIRA).  Both of them are “individual retirement arrangement” accounts that can be set up with financial institutions like banks, brokerage firms, or investment management companies.  You can contribute certain amounts of money into these accounts for the purpose of retirement savings, and in return, the government provides tax benefits. What makes a RIRA different from a TIRA is when and how the tax benefits are received.

Traditional IRA

A TIRA provides tax benefits today.  For example, if you contribute $5,000 into a TIRA in 2013, you may be able to deduct that contribution from your taxable income for the year (assuming you qualify).  In other words, this could lower your tax bill for the current year.  As a simple example, if you pay 20% income taxes and you remove $5,000 from your taxable income, then you could reduce your tax bill by $1,000 ($5,000 x 20% = $1,000).  This upfront tax benefit makes the TIRA a popular choice.

Once the money is inside the TIRA it grows tax-deferred.  In other words, as the money grows from interest, dividends, and investment gains, you don’t have to pay taxes on the money as long as it stays inside the TIRA. In a taxable account, those things could be taxed on an annual basis. When you pull the money out of the TIRA, the distributions will be subject to income tax at that time (you may be subject to penalties as well if the funds are pulled out before age 59.5).

Roth IRA

A RIRA provides tax benefits in the future.  For example, if you contribute $5,000 into a RIRA in 2013, you will not receive any tax benefit for the year (i.e. you cannot deduct the contribution from your taxable income).  As with the TIRA, the money will grow without taxes as long as it stays inside the RIRA. In the future, when you pull the money out of the RIRA, distributions will not be subject to tax.  In other words, all of the interest, dividends, and capital gains accrued inside of the RIRA become tax-free.

There are conditions of course, including the need to hold the RIRA for at least five years to avoid early withdrawal penalties.  Regardless, the RIRA is one of the very few ways to make “tax-free” money in the US.   This is a unique and valuable benefit, but one that can take a long time to capture versus the “here and now” benefit of a TIRA.  So which is better?

To Roth or Not

Before we get ahead of ourselves, let me point out that some people simply don’t qualify for Roth contributions.  For example, in 2013 if your modified adjusted gross income (MAGI) is above $127,000 (single filing), you may not even be eligible for Roth contributions, to begin with.   You may be able to pull off a Roth conversion, but that could cause other problems and may not be a good choice (which all depends on your personal circumstances, so you should consult your tax advisor to be sure).  The conversion is an entirely separate conversation in of itself, so we’ll revisit it another time.  For now, let’s get back to Roth versus Traditional.

As I wrote above it depends on a number of variables.  One variable is your income level, both now and in the future.  Many people will experience their highest income levels and tax rates prior to retirement, with both decreasing after retirement.  In that sense, deductions during higher income periods may be more valuable than tax-free benefits during periods of lower income.  Another variable is the tax code.  If tax rates, in general, are lower during your retirement than they were before your retirement, then the tax-free benefit of the RIRA is diluted and could even be counterproductive.  Given that many people expect tax rates to go up from here, this may not be a concern.

Then there are your other moving parts to consider.  For example, if you’ve already reached your 401(k) contribution limits for the year, you may not receive any additional upfront tax benefits for a TIRA.  So in that case, it could make sense to capture the future benefits of the RIRA (assuming you qualify).   And then there are also advanced considerations like estate planning issues.   For example, if your objective is to leave the money to your heirs, you should know that the TIRA has required minimum distributions (RMD) at age 70.5 but the RIRA does not.  The lack of RMD helps preserve tax benefits and can maximize the value of your bequest.  Also, the tax treatment of TIRA and RIRA may be different for heirs, is that something you care about?  The answers to these questions can be personal and subjective.

The Bottom Line

Clearly, there are many variables to consider and so the answer of whether to use a Roth or not isn’t a simple “yes” or “no.”  It’s important to recognize that many of the variables affecting the RIRA outcome are beyond our control (i.e. tax rates, investment performance, and so forth), so there is a speculative element.  With that in mind, the safest choice is often a balanced one.  Contributing to a mix of different accounts is a prudent approach that will help you avoid having all your money in the wrong place at the wrong time (which is the worst possible outcome).

If you don’t know where to start, we’d recommend beginning with a financial plan.  Instead of looking at the RIRA decision in isolation, it makes sense to consider all of your different moving financial parts and to identify which strategies, when combined, will produce the optimal overall outcome for your goals and needs. To that end,  BCM is here to help, so feel free to reach out with any questions or needs.

Victor K Lai, CFA

This blog is for informational purposes only. Nothing on this blog represents advice. Investing is inherently risky and involves the potential for loss. Victor Lai does not own any of the securities referenced in this posting. Clients of Bellwether Capital Management LLC may own shares of the securities referenced in this posting.