Roth IRA Basics


From the August 2010 newsletter:

It almost seems like the US retirement system was designed to keep people like me employed. There are no less than four major types of accounts people can use for retirement–and there are plenty more out there. Of these, the Roth IRA is this year’s hot topic, because now everyone can convert Trad IRAs into a Roth (high earners were previously excluded). However, the income limit for contributions still applies.

Account Type Contributions Earnings Withdrawal Similar Accounts
Taxable No deduction Income or capital gains tax Capital gains tax
Roth IRA No deduction None None Roth 401k
Traditional IRA Deduction None Income tax SEP IRA, 401k, 403b
Non-Deductible Trad IRA No deduction None Income tax on earnings Tax-deferred annuity

Looking at these account types, here are some quick observations:

  • Roth IRAs are better than taxable accounts and non-deductible Trad IRAs. Contributions to these accounts do not provide a tax deduction, however a Roth IRA avoids all future taxes.
  • Non-deductible Trad IRAs are better than taxable accounts if you’re willing to convert it to a Roth IRA. If you don’t convert, you need to weigh the benefit of tax-deferred growth vs the downside of paying income tax on earnings–currently a much higher rate than capital gains tax.
  • In general, Roth IRAs are better than Traditional IRAs if you expect your future tax rates to be around the same or higher than today’s rates. If you expect your tax rate to drop in the near term, you can contribute to a Trad IRA today, then convert when your tax rate drops. If your tax rate stays roughly the same, the Roth IRA is better because it’s economically bigger, so more of your money is growing tax-free.

Based on that, here are some rough guidelines for using Roth IRAs.  Use the income table at the bottom to see where you fall.  And as always, consult your accountant before doing anything serious, like a Roth conversion.

  • If you qualify to deduct Trad IRA contributions:
    • If you expect your tax rate to drop in the future (the longer your wait, the more it has to drop), contribute to a Trad IRA and convert to a Roth then.
    • Otherwise, contribute to a Roth IRA.
  • If you qualify to contribute to a Roth IRA, but not the Trad IRA deduction:
    • Contribute to a Roth IRA.
  • If you don’t qualify for either:
    • If you don’t have existing Trad IRAs, contribute to a non-deductible Trad IRA then immediately convert to a Roth IRA, you cheater.
    • If you already have Trad IRAs (including Rollover IRAs, SEP IRAs, etc), then it gets tricky because you cannot convert just the non-taxable portion of your Trad IRAs. The IRS aggregates all your Trad IRAs and then calculates the taxable portion pro rata.  The answer here unfortunately is “it depends.”
Bracket or Phase Out Single Married (Joint)
25% bracket begins (taxable income) $34,000 $68,000
Trad IRA deduction phase out (modified AGI) $56-66,000 $89-109,000
28% bracket begins (taxable income) $82,400 $137,300
Roth IRA phase out (modified AGI) $105-120,000 $167-177,000
33% bracket begins (taxable income) $171,850 $209,250

If you can’t get enough of Roth IRAs, here are more resources:

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