Traditional 401(k)s and IRAs give you a tax break while you're saving for retirement, but income tax is due on each withdrawal from the account. With a Roth IRA, you contribute after-tax dollars, but withdrawals from these accounts, including the earnings, are often tax-free. To decide which type of retirement account is best for you, you need to compare your current tax rate to what you think your tax rate will be in retirement. "If you will be in the same or a higher tax bracket in retirement, the Roth IRA is the better choice," says William Keffer, a certified financial planner for Keffer Financial Planning in Wheaton, Ill. "If you will be in a lower bracket in retirement, then the benefit is much less if existent at all." Here are some reasons to do at least some of your retirement saving in a Roth IRA:
Retirement flexibility. Retirees are required to take distributions from their traditional 401(k)s and IRAs each year after age 70 1/2, and income tax is due on each withdrawal. The penalty for failing to take required minimum distributions is a 50 percent excise tax on the amount that should have been withdrawn in addition to the regular income tax due on the withdrawal. But retirees are not required to take annual distributions from Roth accounts, which gives them more flexibility to withdraw the money only when they need it.
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Tax diversification. Having some of your retirement money in pre-tax accounts and some in after-tax accounts adds tax diversification to your portfolio. "If you can do both, do both. You're diversifying the tax characteristics of your retirement money," says Neal Van Zutphen, a certified financial planner and president of Intrinsic Wealth Counsel in Mesa, Ariz. "When I'm in retirement, I may be able to manage my taxable income and still meet my retirement needs by only taking so much out of my traditional IRA and taking the rest out of my Roth IRA to keep me in the lowest tax bracket." Whether or not your Social Security benefits will be taxable is dependent on your adjusted gross income and traditional IRA withdrawals--but not Roth IRA distributions--count as income.
Easier to access money before retirement. If you withdraw money from a traditional IRA account before age 59 1/2, a 10 percent early withdrawal penalty will be applied to the distribution in addition to regular income tax. But for early Roth IRA distributions, you will need to pay income tax and the early withdrawal penalty only on the portion of the withdrawal that comes from earnings, assuming the account is at least five years old. "Some younger investors may want to start saving for a house and a Roth is a great place to do it," says Bruce Stoltenberg, a certified financial planner and chairman of SoundView Advisors in Olympia, Wash. "They can access that principal without taxes or even owing a penalty." Additionally, the IRA exceptions to the early withdrawal penalty, including a first home purchase, higher education expenses, and unreimbursed medical costs, also apply to Roth IRA withdrawals.
Leave money to heirs. You are required to take traditional IRA withdrawals throughout the later part of your retirement, and your heirs will need to pay taxes on any money left to them as they withdraw it. But you can leave money in a Roth IRA as long as you live, and your children and grandchildren may be able to receive tax-free distributions. "A Roth is an ideal estate-planning tool," says Stoltenberg. "If you suspect that you have a portion of your estate that you are never going to use yourself, a Roth is a wonderful place to have it."
Convert your existing savings to a Roth. High-income workers are restricted from saving in Roth IRAs, but people at any income level can convert all or part of their traditional IRA balance to a Roth IRA. Income tax will be due on the amount converted, which can result in an unusually hefty income-tax bill if you convert a large amount. Large rollovers can also impact your tax bracket, Medicare premiums, and your child's eligibility for federal financial aid for college. Many financial advisers recommend spacing out your conversions over several years, or trying to do a conversion in a year when you have an unusually low income. "You don't have to do it all in one year for the entire account. You could nibble away every other year," says Van Zutphen. "In one particular year, if you had a lot of tax losses, you could do it in a year when you fall into a lower tax bracket."
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