Think about Roth IRAs
For some people, it’s abundantly clear that setting up a Roth IRA, where you get no tax deduction for the contribution but have no taxable income when amounts are distributed, makes perfect sense. People just starting out on their working careers, who might be in a very low tax bracket, are probably better off using the Roth IRA because the tax savings from a traditional IRA deduction don’t help very much. If someone who has a traditional IRA has sufficient wealth that he or she will never need the IRA assets to live on, converting to a Roth IRA makes sense, because there are no required distributions at age 70 1/2, so the IRA funds can continue to build up for the owner’s entire lifetime; and the next generation can withdraw the funds over their life expectancy and will pay no federal income tax on the distributions: a powerful tax planning technique.
But most people aren’t in either of those situations: they’re well into their careers and in a higher tax bracket, and they are likely to need the IRA funds in retirement. In that situation, the question of Roth versus traditional IRA is more difficult to answer. It’s certainly wrong to say that Roth is always better. If an individual is likely to be in a lower federal income tax bracket after retirement, that’s a factor favoring a traditional IRA. But traditional IRA distributions add to adjusted gross income, which can affect taxation of Social Security benefits and could reduce itemized deductions. But most people will be taxed on 85% of Social Security (which is the highest level of inclusion) anyway. So it’s a matter of careful analysis to decide whether to continue with the traditional IRA or convert to a Roth IRA, which requires that you pay tax on the built-up income in the IRA; and whether to make current contributions to one or the other type of IRA.
Conversion from a traditional to a Roth IRA works best when you’re in a lower tax bracket, and when the potential gain on converting the traditional IRA is lower because the market value of the assets is down. So, market turndowns are a time to think about conversion. Some commentators suggest a partial conversion that will bring you to the top of a tax bracket but not push you into a higher one. Remember too that conversion before age 59 1/2 results in a 10% penalty, so that’s rarely a good idea. You’re better off paying the taxes on the conversion with assets outside the IRA, to get the most benefit from conversion. And, finally, remember that if you convert to a Roth IRA and the assets in the IRA then decline in value, there is a technique, recharacterization, by which you can undo the conversion, but not for long.
Think carefully about the Roth option, both contributions and conversions. It’s valuable for some people, a wash or somewhat disadvantageous for others.