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TAX TIME! Is a Roth election right for you and your family?

Meridian Points

April 15th is almost here and many folks are contributing to IRAs. Saving for retirement is always a good idea! Once you decide to fund an IRA, you must then decide if you want to contribute to a Roth IRA or a Traditional (Pre-Tax) IRA. How should you make this decision?

Dave Ramsey and other financial pundits advise everyone to contribute to a Roth. I do not agree with this. I have found that the best strategy for you depends on your tax bracket and your financial circumstances. Every article I read says to “consult your tax advisor”. This is good advice!

What is the difference between a Roth IRA and a Traditional (Pre-Tax) IRA?

Contributions to a Roth IRA or Roth 401(k) are not tax-deductible. The benefit is that, if certain requirements are met, the earnings on Roth accounts are not (under current law) taxable. Other benefits include no requirement to take distributions from a Roth IRA. Additionally, your beneficiaries – including children and grandchildren – will be eligible to receive tax-free distributions.

Contributions to a Traditional or (Pre-Tax) IRA or 401(k) are tax-deductible. There are two primary benefits. First, you get an immediate tax deduction. The second benefit is that earnings accumulate tax deferred until you withdraw them, usually at retirement. Distributions from Traditional IRAs and 401(k)s are taxable as ordinary income.

Are You in the Top Tax Bracket?

My opinion is that those in the top tax brackets should generally not elect Roth treatment for your IRA contributions and 401(k) deferrals. Married folks with taxable income over $460,000 and single filers with taxable income over $410,000 are taxed at a marginal rate of 40% or more. I think that most people in the top brackets should be able to withdraw this money in retirement at a lower rate. The 28% tax bracket goes up to $226,000 for married and $189,000 for singles.

Are You in the Lower Tax Brackets?

Those in the lower tax brackets generally would be better served not electing Roth treatment unless it is likely that he or she will be in a much higher tax bracket in the future. This is because most middle class retirees are able to arrange their finances so that they pay very little federal income tax in their retirement years. Therefore, those in the lower income brackets should usually take the tax deduction today and increase the amount you are putting in your tax-deferred account.

Example 1: A married couple does their budget and determines that they can afford to contribute $4,000 per year to an IRA account. Their $145,000 taxable income is likely to remain steady in the coming years. They are in the 25% tax bracket. Are they better off by investing $4,000 in a Roth IRA or $5,000 ($4,000 plus the tax savings of $1,000) into a Traditional IRA?

Answer: Most people in this situation will find that they are better off not electing Roth treatment because they will probably be in the 15% bracket when they retire. Also, the long term benefit of banking the $1,000 tax savings each year becomes very significant as time passes.

Example 2: Joe, age 28 is just getting started at his company. He earns $40,000 per year today. People with five years experience at his company make $75,000. He is in the 15% tax bracket. Should he contribute to a Roth or to a Traditional IRA?

Answer: Joe should elect Roth treatment because he will look back very soon with nostalgia at his 15% tax bracket. The long term benefit of earning money tax-free in his Roth IRA will soon outweigh the benefit of the today’s tax deduction.

Are You in the Middle Tax Brackets?

Those in the middle tax brackets (taxable income between $150,000 and $400,000) face a much more difficult choice. The first order of business is to maximize your contributions. Those under 50 can contribute a maximum of $18,000 in 401(k) deferrals (5,500 in an IRA) while those 50 and older can contribute $24,000 ($6,500 in an IRA). After maximizing your contributions, you need to evaluate your tax situation both today and in your retirement years. Is your tax rate when you retire going to be lower or higher? Some people would rather take the tax deduction today because they have very few deductions. Others say that the security of having tax-free income makes electing Roth treatment more attractive. There is no general right or wrong answer. It depends on you, your personality, the other investments you own, and your tax situation.

What about Your Children and Grandchildren?

A person must have earned income (i.e. W-2 wages) to contribute to an IRA. Consider giving your child or grandchild the gift of an IRA account as a way to get them started in the world of saving.

Example A: Sharon’s grandson has a job at McDonalds that pays him W-2 income of $2,500. Sharon wants to make a gift to her grandson. She should consider opening a Roth IRA for him. The grandson does not need a tax deduction today and the $2,500 will grow tax free to more than $25,000 when he retires 50 years from now.

Example B: Cindy and Bruce have two children who are just getting started as working adults. Cindy and Bruce want to make gifts to their children, but they want the children to save the gift. They can give each child up to $5,500 to fund a Roth IRA. If they do this for five years, each of their children will accumulate over $165,000 tax-free at retirement. Note that there are income and other limitations when employing this strategy.

Should You Convert a Traditional IRA to a Roth IRA?

You can convert your Traditional Pre-Tax IRA to a Roth IRA. This involves paying the income taxes today for the benefit of never having to pay income tax on the distributions in the future – as long as certain requirements are met. This strategy works best for those who (1) have the money to pay the tax, and (2) do not need the cash in your IRA or 401(k) for retirement living expenses. I would not even think about doing this without the blessing of your CPA.

So is a Roth IRA right for you?

It depends on your circumstances. Above all, saving is the most important thing; Roth or Traditional is simply a detail.

Email me if you have questions or need assistance…

Meet the Author

Tom Coulter, CPA


Tom is the President and a founder of Meridian Trust. Tom graduated from The University of Tennessee, Knoxville, in accounting with honors, in 1978. Tom previously worked for the international accounting firm, Deloitte. He later joined the financial medical advising firm, FIS Associates, before founding Meridian Trust in 1997. Tom has worked extensively in retirement planning, taxation, estate and financial planning and investment management. He is a Certified Public Accountant, a member of the American Institute of CPAs (AICPA), and the Tennessee Society of CPAs (TSCPA). Tom is also credentialed as a Personal Financial Specialist (PFS) by the AICPA.