Retirement Planning: To Roth or Not to Roth?

Michael Laine | Apr 5, 2021

When saving for retirement, it often makes sense to contribute to employer-sponsored retirement plans to take advantage of any available employer match opportunities. However, not everyone has access to an employer-sponsored plan. Even if you do, there are reasons you may want to consider using Traditional and/or Roth IRAs to supplement your retirement savings. There are important differences between the two types of accounts.[i] Understanding the potential benefits and drawbacks of each type of IRA can help you make more informed decisions.

Potential Benefits and Considerations

Regardless which type of IRA you choose, the contribution limits are the same, although Roth IRAs contributions are subject to income limits.[ii] Traditional IRA contributions are not limited by income levels unless you or a spouse was covered by an employer-sponsored plan during the year of the contribution. In 2021, the total amount you can contribute to your Traditional and Roth IRA accounts is the lesser of your taxable compensation for the year or $6,000 ($7,000 for those age 50 or older.)[iii]

However, there are important differences in tax treatment for these accounts. If your income is below certain thresholds, you may be able to deduct some or all of your contributions to traditional IRAs, reducing your taxable income in the year of the contributions.[iv] Taxes on contributions and any growth are deferred until you begin withdrawing them. So, if your tax bracket in retirement is lower than in your earning years, you may pay less in taxes on your retirement dollars.

In contrast, you cannot deduct contributions to a Roth IRA – those are after-tax contributions.[v] However, qualified distributions from Roth IRAs are not subject to federal income taxes, potentially lowering your tax burden in your retirement years.[vi] Generally speaking, Roth IRAs may make sense for investors who expect to be in a higher tax bracket in their retirement than in their working years. And, unlike Traditional IRAs, Roth IRAs are not subject to IRS Minimum Required Distribution rules, giving account owners more control over deciding when to access and use their retirement accounts.[vii]

Roth IRA Conversions

If the idea of using a Roth IRA to supplement your retirement savings appeals to you but you do not meet the income limits to contribute to one, you may want to consider making non-deductible contributions to a Traditional IRA and then converting the account to a Roth IRA. There are no income limits for Roth IRA conversions.[viii]

A Roth conversion changes an existing traditional IRA or 401(k) into a Roth IRA, converting the assets so they will grow on a tax-free basis, rather than a tax-deferred one. However, the catch is that you must pay income taxes on any previously untaxed amount converted, in the year of conversion.[ix] There are also rules specifying that you must leave converted dollars in the Roth IRA account for at least five years before withdrawing them. Withdrawing them before the five years are up may subject you to a 10 percent penalty on the withdrawn amount.[x]

Seek Guidance and Weigh Your Options Carefully

Ultimately, there is not a bright-line test to determine whether a Traditional or a Roth IRA is best; the answer depends on your current situation and anticipated circumstances in your retirement years.

If your income has dropped so you are in a lower tax bracket in 2020 than in previous years, it may make sense to consider a Roth contribution or conversion. Or, if you are concerned about your tax obligations for 2020, you may be able to make a deductible contribution to a traditional IRA by April 15, 2021.[xi]

Talk to your financial professional to learn more about different types of retirement planning vehicles, and to explore whether a Roth IRA may make sense for you.

Important Disclosures:

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.

The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change.

Traditional IRA account owners should consider the tax ramifications, age and income restrictions in regards to executing a conversion from a Traditional IRA to a Roth IRA. The converted amount is generally subject to income taxation.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy.

[i] https://www.irs.gov/retirement-plans/traditional-and-roth-iras

[ii] https://www.irs.gov/taxtopics/tc309

[iii] https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits

[iv] https://www.irs.gov/retirement-plans/ira-deduction-limits

[v] https://www.irs.gov/retirement-plans/roth-iras

[vi] https://www.irs.gov/publications/p590b#en_US_2019_publink1000231061

[vii] https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds

[viii] https://www.thebalance.com/should-you-do-a-roth-conversion-2894481

[ix] https://www.fool.com/retirement/plans/roth-ira/conversion/

[x] https://www.businessinsider.com/roth-ira-5-year-rule

[xi] https://www.irs.gov/retirement-plans/ira-year-end-reminders