Saving & Investing
Is a Roth IRA right for you?
August 20, 2012
Rebecca Katz: I know that sometimes the decision between Roth or traditional—and the tax advantages of each—can be a little confusing for investors, especially around conversions. So maybe you could take us through some of the nuances of that.
Joel Dickson: Sure. Although we've been talking IRA, the same sort of discussion might work for 401(k)s too, if you think about traditional, or if you have a Roth option in a 401(k).
Generally, we're talking about whether—sometimes, it's referred to as "front-loaded" or "back-loaded" benefits. That is, do you get the tax benefit up front, like you do with a traditional IRA or 401(k)? Or, do you get the tax benefit at the end, like you do with the Roth IRA or Roth 401(k)?
We actually have a little chart that shows a base-case type scenario. And I think probably many people are familiar with the concept of the decision that whether you convert or even contribute to a Roth IRA or a traditional IRA is largely dependent on your tax rate and, namely, what your tax rate is today versus what you expect your tax rate to be in the future.
The general rule of thumb that's out there—and we'll explain that, you know, this is correct to a certain point—is that if your tax rate is going to be higher in retirement than it is today, then you'd want to think about converting, because you pay a lower tax today; you avoid a higher tax tomorrow.
Similarly, if your tax rate is expected to be lower in retirement, you might want to think about not converting, or keeping that traditional IRA, or contributing to a traditional IRA, because you get a higher tax benefit now and you'll pay at a lower rate in the future.
And if you're unsure of what the rates will be or, you know, you think they might be the same, then you might invest in both, from what we call a "tax diversification angle," which I'm sure will probably come up again.
That said, that general rule of thumb is for a very special case. And that's where all of the contributions are otherwise tax-deductible, you know, into the traditional IRA. And that's not always the case, and there are lots of reasons why. You talked in the polling question just a moment ago, that there are some risks or some concerns with making a conversion, but there are also a number of things that can benefit a Roth IRA conversion relative to a traditional IRA holding.
For example, Maria mentioned the 'no required minimum distributions.'
Maria Bruno: Right.
Joel Dickson: That can tilt things slightly in the favor of a Roth IRA in certain cases, but, also, if you've made nondeductible IRA contributions. Often times, if you're over certain income limits, you can only make nondeductible traditional IRA contributions.
Well, converting those to a Roth may actually be quite beneficial, and it may be beneficial even if your tax rate is lower in the future. And I can give a quick example on that. Let's say you have a $10,000 IRA. If it's all nondeductible contributions—so that the value and the basis are the same, if you will, you'd owe no tax if you converted today—if you convert it, you would owe no tax on whatever that $10,000 grows to over time, assuming you meet the conditions of a Roth conversion, and holding period, and so forth.
If, however, you don't convert, every additional dollar that you earn in investment return is actually taxable—because it is earnings in the account—when it is taken out.
So even if your tax rate is 5% in retirement, you would still prefer to convert, because no further taxes would be due under that situation.
So there you can see that it can make a difference where your nondeductible contributions are, as a percent, or as a value of your total IRA holding. And the more nondeductible contributions that you have, the lower the hurdle rate is in terms of your future tax burden, where the Roth conversion wouldn't make sense.
Excerpt from a live Vanguard webcast
Joel Dickson of Vanguard's Investment Strategy Group and Maria Bruno of Investment Counseling & Research describe the various scenarios of investing in or converting to a Roth IRA. Mr. Dickson also says there are certain situations when converting to a Roth IRA can make sense—even for those who otherwise might choose a traditional IRA.
- All investments are subject to risk. Diversification does not ensure a profit or protect against a loss in a declining market.
- This webcast is for educational purposes only. We recommend that you consult a financial or tax advisor about your individual situation.
- When taking withdrawals from an IRA before age 59 ½, you may have to pay ordinary income tax plus a 10% federal penalty tax.