Traditional vs. Roth IRAs
The decision as to whether to invest in a traditional IRA versus a Roth IRA is an important one.
The potential tax savings, tax costs, tax-deferred accumulations, and tax-free distributions are
very large and investors must understand which IRA will generate the greatest savings and
benefits over time.
This material will explain the differences between these two types of IRAs. These basics must
be understood before one can then decide which is the most advantageous.
Traditional IRAs
Contributions
Deductions
Nondeductible Contributions
Early Withdrawals
Mandatory Distributions
Rollovers and Transfers
Roth IRAs
Distributions
Contributions
Roth Conversion
Traditional IRAs
A traditional individual retirement account (IRA) is a domestic trust or custodial account that can
be established by an individual in order to save money for retirement on a tax-deferred basis.
Some contributions may also be deducted from taxable income in the year of contribution.
A traditional IRA is an extremely versatile and simple way to save for retirement. It is often
used by those with no other tax-favored way to save for retirement. A traditional IRA also
serves as the funding method for retirement plans, like SEPs and SIMPLEs, used by small
business owners and the self-employed.
Taxpayers who do not reach age 70½ by the end of the year and receives taxable compensation
during the year can set up and make contributions to an IRA. Compensation is earned from
working and includes wages, salaries, tips, commissions, and net income from self-employment.
Where spouses are concerned, compensation is pooled between spouses allowing both spouses to
set up separate IRAs even if only one spouse is working. Although there is an upper age limit
for participation, there is no minimum age requirement, with compensation being the only factor
to consider.
Contributions
Through 2007, the maximum that an individual can contribute to a traditional individual
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retirement account (IRA) is $4,000. In 2008, the maximum amount increases to $5,000, and in
2009 through 2010 the $5,000 maximum is increased for inflation. After 2010, the IRA limits
are scheduled to return to the year 2001 levels, although some observers believe that future
legislation may continue the increased limits. For those who are age 50 and over, an additional
catch-up contribution of $1,000 is allowed. The maximum contribution amounts over the next
few years are summarized in Table 1.
Table 1. Maximum IRA Contributions
Year
2005
Under Age 50
$4,000
Over Age 50
$4,500
2006
$4,000
$5,000
2007
$4,000
$5,000
2008
$5,000
$6,000
2009
$5,000+
$6,000+
2010
$5,000+
$6,000+
2011
2001 levels
2001 levels
In 2009 and 2010, the $5,000 maximum contribution is increased by an inflation adjustment; for individuals over
age 50, the maximum in those years is $5,000 increased by an inflation adjustment, plus an additional $1,000.
Contributions and Compensation
As mentioned, a taxpayer must have compensation to make an IRA contribution. Similarly, the
maximum IRA contribution is reduced if it falls below the overall contribution limit for the year.
For example, if a taxpayer has earned income of $2,000 for the year, the most he can contribute
to his IRA is $2,000, even though the limit for the year is $4,000. His IRA contribution for the
year is limited because his level of compensation is lower than the maximum contribution limit.
Timing
Contributions to a traditional IRA can be made for a year at any time during the year or by the
due date for filing the year’s tax return (April 15th). Filing extensions are not counted.
The plan sponsor will send a IRS Form 5498 (or similar statement) showing contributions made
for the year. If you report a different contribution amount on your tax return, expect to receive a
letter from the IRS about the discrepancy.
If an amount is contributed between January 1 and April 15, the IRA custodian must be told
which year (current or previous) the contribution is for. If the sponsor is not informed, it will
assume that it is a contribution for the year received and report it as such to the IRS.
Taxpayers may withdraw contributions without penalty if this is done by the due date of the
return for the year the contribution is made. If an extension to file a return is filed, withdrawals
can then be withdrawn by the due date of the extension. The only additional requirements are
that deductions for the contribution cannot be taken and any earnings on that contribution must
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also be withdrawn. Similarly, losses must be taken into account with the likelihood that the
taxpayer will get back less than the contributions.
Deductions
Amounts contributed to a traditional IRA may be eligible for a full or partial deduction from
taxable income for the year of contribution. This provides an immediate benefit due to the
associated tax savings.
The tax benefits for contributing to a traditional IRA depend on a number of factors, including
income level, filing status, and whether or not the taxpayer is covered by an employer’s
retirement plan.
Tables 2 and Table 3 can help determine eligibility for a full deduction, a partial deduction, or no
deduction. Table 2 is for those covered by a retirement plan at work. Table 3 is for those who
are not covered by a retirement plan at work.
Table 2. 2005 Deduction for Individuals Covered by a Retirement Plan at Work
Modified AGI*:
Filing Status
Single/
Hd of
House
MFJ**/
Qual
Widow(er)
Married
Filing
Single***
At Least
But Less Than
$0.01
$10,000
Full
Full
Partial
$10,000
$50,000
Full
Full
None
$50,000
$60,000
Partial
Full
None
$60,000
$70,000
None
Full
None
$70,000
$80,000
None
Partial
None
$80,000
or over
None
None
None
*Modified AGI (adjusted gross income) is determined using Worksheet 1-1 in IRS Publication 590, Individual
Retirement Arrangements (IRAs).
**Even if spouse not covered by work plan.
***If you did not live with your spouse at any time during the year, your filing status is considered (for this purpose)
as single (therefore, your IRA deduction is determined under the “Single” column).
Nondeductible Contributions
Although tax deductions for IRA contributions may be reduced or eliminated, the taxpayer can
still make a nondeductible contribution up to the annual limit for the year. Investors will still get
the benefit of tax-deferred growth.
To designate contributions as nondeductible, the taxpayer must include in the annual tax return
IRS Form 8606. At that time, the taxpayer can designate otherwise deductible contributions as
nondeductible contributions. Failure to file Form 8606 results in a $50 penalty unless the
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oversight was due to reasonable cause. The IRS will automatically treat contributions as
deductible unless it gets Form 8606. If this occurs, the taxpayer is responsible for clearing up the
mistake.
Table 3. Deduction for Individuals Not Covered by a Retirement Plan at Work
Modified AGI*:
Filing Status
MFJ,Spouse Covered
By Work Plan
MFJ or MFS,
SpouseSingle/
Hd of House
Full
Full
Full
Partial
$150,000
Full
Full
Full
None
$160,000
Partial
Full
Full
None
or over
None
Full
Full
None
At Least
But Less Than
$0
$10,000
$10,000
$150,000
$160,000
MFS, Not Covered Spouse Covered
by Work Plan/
By Work
Qual Wid
Plan**
*Modified AGI (adjusted gross income) is determined using Worksheet 1-1 in IRS Publication 590, Individual
Retirement Arrangements (IRAs).
**You are entitled to the full deduction if you did not live with your spouse at any time during the year.
Early Withdrawals
Contributions made to an IRA are not supposed to be available until age 59½. As a practical
matter, taxpayers are always able to withdraw money at any time. Making an early withdrawal
prior to age 59½ , however, will result in a tax penalty and in the full amount of the withdrawal
being subject to ordinary income taxes.
If an early withdrawal is made that does not fall into the exceptions listed below, a person has to
pay regular income tax on the withdrawn amount, plus an additional 10 percent penalty tax on
the amount that is included in gross income. After taxes and penalties are imposed, you will be
lucky to see (let alone use) half the money you take out of your IRA. The 10 percent penalty is
not imposed in the following situations:






You have unreimbursed medical expenses that are more than 7½ percent of adjusted
gross income.
The distributions are used to pay the cost of medical insurance after becoming
unemployed and the taxpayer is receiving unemployment compensation for 12 straight
weeks. The distributions must be received in the year unemployment compensation is
received, or in the following year, and no later than 60 days after becoming reemployed.
The taxpayer is disabled and can furnish proof that no substantial gainful activity is
possible because of the physical or mental condition.
The money is withdrawn as the beneficiary of a deceased’s IRA.
Distributions are being paid in the form of an annuity that is part of an IRS-approved
distribution method.
The distributions are used to pay for qualified higher education expenses (i.e., postsecondary education tuition, fees, books, supplies, and equipment, plus room and board if
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

at least a half-time student).
Distributions are used to buy, build, or rebuild a first home, provided the money is used
to pay qualified acquisition costs before the close of the 120th day after entering into a
contract to buy the home or the construction of the home begins.
The distribution is due to an IRS levy.
Mandatory Distributions
As far as the IRS is concerned, keeping money in an IRA too long is an even worse crime than
taking it out too early. Taxpayers must begin taking periodic distributions by April 1 of the year
following the year in which they reach age 70½. From that point on, taxpayers must compute the
required minimum distribution (RMD), which must be made by December 31 of that year and all
subsequent years.
Example:
Eric Santana reached age 70½ on August 20, 2005. Therefore, he must receive the first RMD by
April 1, 2006. He must then receive the RMD for 2006 (the first year after her 70½ year) by
December 31, 2006. Therefore, the taxpayer must compute and take two RMDs in the same year
and one RMD in the years thereafter. There is nothing to prevent Mr. Santana from taking more
than the RMD if he so chooses.
The penalty for keeping money in a traditional IRA too long is severe. An excise (penalty) tax
of 50 percent is imposed on the amount that is not distributed as required. Then, of course, a
regular tax is imposed once a distribution is finally made.
Calculating Distributions
If the taxpayer decides to not take a lump-sum distribution, he or she must start to receive
periodic distributions over one of the following periods by April 1st in the year following the year
in which the taxpayer turned 70½:


His or her life expectancy, or
The combined lives of the taxpayer and his or her designated beneficiary (i.e., the person
named to receive the IRA upon the taxpayer’s death).
To figure the RMD for each year, the taxpayer should divide the IRA account balance as of each
December 31 of the preceding year by his or her applicable life expectancy for his or her attained
age or for the combined life expectancy of the taxpayer and his or her beneficiary.
If a beneficiary is other than a spouse and the beneficiary is more than 10 years younger than the
taxpayer, a minimum distribution incidental benefit (MDIB) table must be compared with the
regular life expectancy table and the lower number used for the beneficiary’s age.
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Example:
Carlos Clapton reached age 70½ in 2005 and must begin receiving distributions from his IRA by
April 1, 2006. His wife and beneficiary, Olivia, turned 57 in 2005. Carlos’ IRA account balance
as of December 31, 2004, is $29,000. Based on their ages at the end of 2005, the joint life
expectancy for Carlos (age 71) and Olivia (age 57) is 29 years. The required initial minimum
distribution is $1,000 ($29,000 divided by 29 years) and is made from Carlos’ IRA in 2006 by
April 1st. At the end of 2005, Carlos’ IRA balance has grown to $29,725. To figure out the
minimum distribution that must be made by the end of 2006, the $29,725 must be reduced by the
minimum distribution amount for the previous year ($1,000) that was paid in 2006. His required
distribution amount for 2006 is now $1,026 ($28,725 divided by 28 remaining years).
Multiple IRAs
If the taxpayer has more than one traditional IRA, the RMD must be calculated for each IRA.
However, the total required distributions can be taken from any of the IRAs as long as the total
amount is withdrawn.
Example:
Nikki will turn 70½ on September 2, 2005. He has two traditional IRAs, one with $10,000 and
another with $20,000. The minimum amount that must be distributed from each IRA by April 1,
2006 (based on a distribution period of 27.4 years) is $365 and $730 respectively. Nikki decides
to have all of the required distributions come from the smaller IRA because it offers a lower rate
of return. After the RMD occurs, he is left with $8,905 in the first IRA and $20,000 in the
second IRA. He can continue this process until the smaller account is depleted, and then
commence withdrawals from the second IRA.
Rollovers
A transfer of funds directly between trustees is not considered an IRA rollover, but rather a
trustee-to-trustee transfer. A trustee-to-trustee transfer is always tax-free and can be done an
unlimited number of times.
A rollover is a distribution of cash to the plan holder or the distribution of assets from one
retirement plan to another retirement plan, such as between an IRA and an employer’s plan. A
rollover is tax-free provided the entire rollover contribution is made by the 60th day after a
distribution is received. Any amounts not rolled over in time is treated as an early withdrawal
and taxable in the year distributed.
When rollovers occur between traditional IRAs, there is a one-year waiting period before another
rollover of a distribution can be made. The one-year period begins on the date the IRA
distribution is received and not on the date it is rolled over. Also, the one-year period applies to
each IRA owned by the taxpayer.
For example, Justin Case established three traditional IRAs, IRA-1, IRA-2 and IRA-3, in three
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different banks. Justin decides to combine the assets in IRA-1 and IRA-2 into one new IRA,
IRA-4. On July 31, he withdraws the amounts in IRA-1 and IRA-2 as part of a rollover. He
deposits the amount from IRA-1 into IRA-4 on August 29 and the amount from IRA-2 on
September 21. Justin cannot make another rollover of the assets distributed from IRA-1 and
IRA-2 and rolled over to IRA-4 until July 31 of the following year.
On September 1, Justin takes a rollover distribution from IRA-3 that he deposits in IRA-4 on
October 31. He cannot make another rollover of that amount until September 1 of the following
year.
Rollovers to Roth IRAs
A taxpayer (single, married filing jointly, head of household) whose adjusted gross income
(AGI) does not exceed $100,000 for the tax year can roll over a traditional IRA to a Roth IRA.
A person’s AGI is determined before the inclusion in income of any amount as a result of the
conversion. Married individuals who file separately cannot make qualified rollovers from a
traditional IRA to a Roth IRA. Any rollovers involving a traditional IRA must be reported on
the taxpayer’s return for the year the distribution is made.
Inherited IRAs
A traditional IRA inherited from a spouse can be rolled over to the surviving spouses own IRA
or renamed as the surviving spouses own IRA. If a traditional IRA is inherited from somebody
other than a spouse, it cannot be rolled over nor may it receive rollover contributions from the
plan holder who inherited the IRA. Instead, the taxpayer is required to withdraw and pay tax on
the inherited IRA assets.
Transfers Related to Divorce
Just like any other item of property being contested in a divorce, a traditional IRA may be
transferred between divorcing spouses. The transfer is tax-free if transferred under a divorce or
separate maintenance decree or a written document related to such a decree. The two commonly
used methods to make the transfer are changing the name on the IRA or making a direct transfer
of IRA assets to the receiving spouse’s IRA. The date of transfer determines when the
transferred IRA or IRA assets belong to the receiving spouse.
Roth IRAs
Taxpayers still question whether or not they should contribute to a Roth IRA or a Traditional
IRA. They also question whether they should convert or rollover a portion of their traditional
IRA into a Roth IRA. The answers to these issues depend entirely on assumptions about the
future.
Roth Basics
A Roth IRA is not an investment. Instead, it is a tax-deferred savings option that is a wrapper for
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an individual’s retirement assets. Roth IRAs can hold any combination of stocks, bonds, mutual
funds, and other permitted IRA investments. There is no guaranteed rate of return for a Roth
IRA. The return is based on the performance of the portfolio that is inside of the Roth. A Roth
IRA grows tax-deferred and, if certain conditions are met, distributions from the IRA will be taxfree for federal income tax purposes. Contributions to Roth IRAs are not deductible on an
individual’s federal income tax return, and therefore, contributions are made with after-tax
dollars.
The Benefits of a Roth
A Roth IRA provides an individual with several benefits that are not available from a traditional
IRA. The main benefit allows for all qualifying distributions to be free from federal income
taxation. An individual may still be able to take distributions prior to age 59½ and not incur any
income tax or premature distribution penalty. Distributions are taxed on a ‘first in-first out’
(FIFO) basis meaning that the first dollars to be withdrawn will be principal on which no tax
liability is incurred. Only the portion of a distribution that represents investment earnings will be
taxed and subjected to a penalty.
Roth IRAs provide additional benefits to individuals that are age 70½ or older that are not
available from a traditional IRA. An individual may continue to make contributions to a Roth
IRA even after age 70½ as long as they have taxable compensation income, whereas
contributions to a traditional IRA are not be permitted once that age is reached.
Unlike traditional IRAs, Roth IRAs are not subject to the RMD rules, which requires that
individuals take annual minimum distributions when the IRA owner reaches age 70½. Because
Roth IRAs are not subject to the minimum distribution rules, individuals are able to continue to
grow the value of their Roth IRA tax-free. This can be a significant benefit for individuals
looking to transfer wealth to future generations upon their death.
Beneficiaries of a Roth IRA will continue to enjoy income tax-free distributions from Roth IRAs
upon the owner’s death. The tax-free distributions still apply, as long as the original owner
satisfied the five-year holding period requirement as described below. However, Roth IRAs are
included in the owner’s taxable estate and may be subject to estate tax.
Distributions
The main attraction of a Roth is tax-free distributions. However, in order for Roth IRA
distributions to be completely income tax-free, the distributions must satisfy a five-year holding
period, plus they must meet one of the following conditions:




The distributions are made on or after the date on which the individual attains age 59½;
or
The distributions are made to a beneficiary on or after the individual’s death; or
The distributions are made due to the individual being disabled; or
The distributions are made to pay qualified first-time homebuyer expenses (lifetime limit
of $10,000).
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To meet the five-year holding period requirement, a distribution from a Roth IRA must not occur
before the end of the five-year holding period, which begins with the first taxable year in which
the taxpayer made a contribution to the Roth IRA. Once an individual has met the five-year
holding period requirement on their initial contribution, all future contributions are not subject to
a new holding period requirement. However, the treatment of distributions associated with Roth
IRA conversions may be different. If a distribution from a Roth IRA does not meet the holding
period requirement, the distribution amount may be included in the individual’s taxable income
and may be subject to the 10 percent premature distribution penalty.
There are specific ordering rules that determine the taxation of distributions from Roth IRAs.
Distributions are deemed to come first from regular contributions, then from amounts converted
or rolled-over from traditional IRAs, and finally from earnings.
Roth Contributions
In order for an individual to make a contribution to a Roth IRA in a given year, he or she must
have compensation income. This includes wages, salaries, commissions, self-employment
income, and taxable alimony received.
The maximum annual contribution that can be made to a Roth IRA is the same as for traditional
IRAs. In 2007 this amount is $4,000 and $5,000 for tax year 2008. Starting in 2009, the
maximum contribution to a Roth IRA will contain an annual inflation adjustment. In addition,
taxpayers 50 years of age or older are permitted to make catch-up contributions of an additional
$1,000 to a Roth IRA.
Table 1. Roth IRA Contribution Limits for 2007
Tax Status
Allowable Roth IRA Contribution Based on Modified Adjustable Gross
Income (MAGI)
Maximum
Partial
None
Single taxpayer or head of household
MAGI under
$95,000
MAGI $99,000 to under
$114,000
MAGI: $114,000 or
more
Married filing joint or qualifying
widow(er)
MAGI under
$156,000
MAGI $156,000 to under
$166,000
MAGI: $166,000 or
more
Married filing separately
N/A
MAGI: $0 to under $10,000
MAGI: $10,000 or
more
Contribution Eligibility
In order for an individual to make the maximum contribution to a Roth IRA, the individual’s
modified adjusted gross income (MAGI) must not exceed certain levels as shown in Table 1
(above). Single taxpayers and married taxpayers filing a joint return with modified adjusted
gross income below $99,000 and $156,000, respectively, will be eligible to maximize their
contributions to a Roth IRA. Single taxpayers will not be eligible to make Roth IRA
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contributions if their modified adjusted gross income exceeds $114,000, and their contributions
will be gradually phased-out if their modified adjusted gross income is between $99,000 and
$114,000. The modified adjusted gross income cap for married taxpayers filing a joint return is
$166,000 and their phase-out limits are between $156,000 and $166,000.
Evaluating a Contribution
If an individual is eligible to make a Roth IRA or a traditional deductible IRA contribution, the
individual must consider their income tax rates and time horizons. The individual’s income tax
rates both during the periods of contribution and periods of withdrawal need to be analyzed.
With a traditional IRA contribution, the individual would receive a tax deduction in the year in
which the contribution is made. Conversely, Roth IRA contributions are made with after-tax
dollars. If the individual anticipates being in a higher income tax bracket in retirement, it would
most likely be beneficial to forego the current tax deduction and make a contribution to a Roth
IRA. The same would hold true if the individual expected to be in the same tax bracket during
the contribution and withdrawal years.
The decision to make a traditional IRA contribution or a Roth IRA contribution is not as clear if
the taxpayer is expecting to be in a lower tax bracket during the withdrawal years, and depends
on various other factors, such as:



What is the expected tax bracket during the IRA distribution years?
How much lower is it compared to the current tax bracket?
How long does the taxpayer expect that the money may grow before distributions must
begin?
Table 2 and Table 3 provide examples showing how the results differ based on these variables.
Table 2. Traditional IRA vs. Roth IRA: Distribution in 10 Years
Traditional (Deductible) IRA
Higher Tax Rate
Contribution Yr
Tax Rates
Unchanged
Lower Tax Rate
Contribution Yr
Roth
IRA
Marginal Tax Rate: Contribution Year
25%
25%
25%
Marginal Tax Rate: Distribution Year
15%
25%
28%
$3,000
$3,000
$750
$750
$750
N/A
Tax Benefit: Investment Fund (after 10 years)
$1,259
$1,251
$1,249
N/A
IRA Account Balance (after 10 years)
$5,901
$5,901
$5,901 $5,901
Taxes Upon IRA Distribution: Year 10
($885)
($1,475)
Net Assets After Taxes: Year 10
$6,276
$5,677
IRA Contribution Amount: Year 1
Tax Benefit: Year 1
10
25%
N/A
$3,000 $3,000
($1,652)
N/A
$5,498 $5,901
Assumptions:
$3,000 contributions made in Year 1
Rate of return of IRAs: 7%
Rate of return of Investment Fund: 7% less each year’s marginal tax rate
No distributions made until Year 10, complete distribution in year 10
Marginal tax rate for each year is 25%, with the exception of distribution year
Table 2 compares the results when distributions occur after 10 years for contributions made to a
traditional deductible IRA and to a Roth IRA. For the traditional IRA contribution, the analysis
considers three different tax scenarios: a tax rate that is higher during the contribution year
compared to the rate during the distribution year, an unchanging tax rate, and a tax rate that is
lower during the contribution year compared to the rate during the distribution year.
To make the $3,000 deductible contribution to the traditional IRA comparable with the $3,000
after-tax Roth IRA contribution, an investment fund consisting of the tax benefit – the IRA
deduction – is set up. This earns an annual after-tax rate of return. The net after-tax amount for
the deductible IRA after 10 years consists of the IRA account, less taxes due on the IRA
distribution, plus the tax benefit investment fund.
Table 3 performs a similar analysis, but shows after-tax values when the assets are allowed to
grow for 35 years. Another tax savings vehicle available to most taxpayers is their employersponsored 401(k) plans. The decision as to whether to contribute to an employer’s non-matching
401(k) plan or a Roth IRA is dependent upon the same facts and circumstances as the traditional
IRA versus the Roth IRA. With the 401(k) plan, the individual receives a current tax deduction
in the year of contribution, but the total amount of the distributions will be subject to income tax.
However, if the individual’s 401(k) offers an employee match, the individual should consider
contributing first to the 401(k) to the extent of the employer match, then to a Roth IRA, and then
any remainder to the 401(k) that is not matched.
Roth Conversion
Individuals who have a traditional IRA may convert to a Roth IRA. In order to convert a
traditional IRA to a Roth IRA, the individual’s MAGI cannot exceed $100,000 in the year of
conversion. Married taxpayers must file a joint return with their spouse in the year of conversion
as well. Therefore, if a married couple decides to file separate tax returns, they will not be
eligible for a Roth conversion regardless of their modified adjusted gross income. The amount
of the traditional IRA that is converted in a tax year is included in the taxpayer’s gross income,
but it is not included in the $100,000 modified adjusted gross income limitation for conversion
eligibility.
In order to convert to a Roth IRA, an individual may either convert a traditional IRA to a Roth
IRA, or rollover IRA funds to a new Roth IRA. Regardless of the method of conversion, the
conversion or rollover is afforded the same treatment for income tax purposes.
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Table 3. Traditional IRA vs. Roth IRA: Distribution in 35 Years
Traditional (Deductible) IRA
Higher Tax Rate
Contribution Yr
Tax Rates
Unchanged
Lower Tax Rate
Contribution Yr
Roth
IRA
Marginal Tax Rate: Contribution Year
25%
25%
25%
25%
Marginal Tax Rate: Distribution Year
15%
25%
28%
N/A
$3,000
$3,000
$3,000
$3,000
$750
$750
$750
N/A
$4,526
$4,496
$4,487
N/A
IRA Account Balance (after 35 years)
$32,030
$32,030
$32,030 $32,030
Taxes Upon IRA Distribution: Year 35
($4,804)
($8,007)
($8,968)
Net Assets After Taxes: Year 35
$31,751
$28,518
$27,549 $32,030
IRA Contribution Amount: Year 1
Tax Benefit: Year 1
Tax Benefit: Investment Fund (after 35 years)
N/A
Assumptions:
$3,000 contributions made in Year 1
Rate of return of IRAs: 7%
Rate of return of Investment Fund: 7% less each year’s marginal tax rate
No distributions made until Year 35, complete distribution in year 35
Marginal tax rate for each year is 25%, with the exception of distribution year
Evaluating a Conversion
One main consideration is where to obtain the necessary funds required to pay the tax upon
conversion. As mentioned above, when an individual converts a traditional IRA to a Roth IRA,
the amount converted to a Roth IRA will be included in the individual’s taxable income in the
year of conversion.
From an income tax standpoint, a conversion to a Roth IRA makes sense only if the individual
has the ability to pay the income taxes on the conversion from a taxable investment account, not
the IRA itself. Although the individual may use part of their traditional IRA to pay the taxes,
this will reduce the amount of funds that will be converted to the Roth IRA and eliminate the
ability for those funds to grow in a tax-free environment. In addition, the funds used from the
IRA to pay the taxes will be treated as a withdrawal and may be subject to income taxes and
possibly a 10 percent penalty for a premature distribution.
Another significant factor to consider is the IRA owner’s current and future expected income tax
rates. If the IRA owner anticipates they will be in a higher tax rate bracket when IRA
withdrawals are made as compared to the tax bracket in the year of conversion, converting to a
Roth IRA will provide the owner an overall lower tax cost on IRA withdrawals. However, if the
IRA owner anticipates that they will be in a lower tax bracket when IRA withdrawals are made,
converting to a Roth IRA may not be the best alternative. Finally, if the IRA owner anticipates
no change in their tax rates between conversion and withdrawal, the income tax effect of
converting to a Roth IRA should be neutral.
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Another consideration is the amount of time that the individual intends on either holding or
taking distributions from the IRA. If an individual anticipates withdrawing funds from their IRA
within five years of conversion to a Roth IRA, converting to a Roth IRA would likely not be
advantageous. A distribution from the Roth IRA within the five-year period that was included in
income during the conversion, likely will cause the distribution to be subject to the 10 percent
penalty on premature distributions.
The age and life expectancy of the IRA beneficiaries may be an important factor to consider
when evaluating a conversion. Although the Roth IRA owner is not required to take any
distributions from their Roth IRA during their lifetime, the IRA beneficiary is not provided the
same luxury, unless the beneficiary is a spousal beneficiary. If a spousal beneficiary is named,
the surviving spouse may be able to treat the IRA as his or her own or rollover the inherited IRA
into their own Roth IRA. Under either method, the surviving spouse is now treated as the owner
of the Roth IRA. Therefore, the surviving spouse’s Roth IRA would not be subject to the
required minimum distribution rules. This would potentially extend the period of time that the
IRA could grow in a tax-free manner. In addition, the surviving spouse would have the ability to
name their own beneficiaries.
If the beneficiary of the Roth IRA is a non-spousal beneficiary, the beneficiary will be required
to take distributions from the IRA after the owner’s death. The beneficiary can choose to take
the distributions under the life expectancy method or the five-year rule. The life expectancy
method allows the beneficiary to take the IRA distributions over their remaining single-life
expectancy. These distributions must begin no later than December 31 of the year following the
year of death. Under the five-year rule, the beneficiary must distribute all funds prior to
December 31 of the fifth-year anniversary of the IRA owner’s death.
In addition to the aforementioned issues, individuals should also consider the following factors
when contemplating a conversion of a traditional IRA to a Roth IRA:
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The IRA owner’s current age and life expectancy;
The IRA owner’s other sources of retirement assets and their anticipated living expenses
during retirement; and
The IRA owner’s other sources of income and taxable investments.
Conclusion
The tax-free growth of the Roth IRA makes it an extremely attractive retirement planning option.
Every individual who is eligible to make contributions to a Roth IRA or eligible to convert a
traditional IRA to a Roth IRA should consider whether a Roth IRA would be beneficial to their
overall retirement planning and wealth transfer goals.
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