Just as it is in any investment, choosing to create (or convert to) a Roth IRA requires analyzing the risk and return of such a strategy. But unlike other investments where risk of loss is compared to possibility of gain, the risk and reward of creating a Roth IRA involves the risk of paying taxes today on the Roth contribution or conversion, and never recouping that amount in the future with tax-free savings from future distributions. I’ll go over a few points to consider when considering the creation of, or converting to, a Roth IRA over a traditional IRA.
Technically, neither the Roth nor a traditional IRA are actual investments, such as a mutual fund or stock; they are simply types of accounts. Whether an IRA is a Roth or a traditional one, you are still exposed to the same market risk based on your asset allocation and risk tolerance. The mere creation of a Roth IRA should not compel the need to alter your asset allocation or risk exposure any differently than you possess with your traditional IRA. But even if there is no market risk in the decision between a Roth and a traditional IRA, there is a unique risk/return relationship with a Roth IRA.
The risk involved in choosing a Roth IRA over a traditional one involves the amount of taxes you are required to pay for the year of the contribution or conversion, and whether you can recoup that amount in future years when you begin to receive distributions tax-free (payments or lump sum)¹.
The reward side of the risk/reward relationship is a little harder to identify for a Roth IRA. Current tax rates and future tax rates are the main variables that should be used to evaluate the creation of a Roth. The current tax rates and your own personal tax situation are relatively easy to determine, but it’s the future tax rates (10 to 20 years from now, for example) and your future tax situation that are more difficult to estimate. However, you can plan for individual tax scenarios incorporating future tax items that are personal to you – Investment withdrawals, capital-gains, Medicare, stock options, real estate, social security, pensions, annuities, etc.
So far in its existence, the Roth IRA has not grown in popularity as one might think considering that the phrase “tax-free” is usually associated with more interest. But I believe it's the "paying taxes" now part (either with after-tax contributions, or lump sum taxes due on conversions) and lack of understanding that creates a reluctance to the possibility, especially when the benefit (tax savings) of the cost is relatively uncertain.
¹ Must be at least 59 ½ and have opened the Roth at least five-years earlier.
But last year’s tax reform and recent pending legislation has rekindled interest in Roth IRA accounts:
Tax Reform - Low individual tax rates by historical standards and a pending reversion in 2026 to the higher rates that preceded the new tax law make consideration of creating a Roth IRA more appealing. We don’t know where our country’s tax rates are headed but paying down a projected $25 to $30-trillion dollar deficit in a few years seems improbable without tax increases of some kind.
“Secure Act” - Recent pending legislation contained a provision about accelerating the distributions from a beneficiary IRA to no more than ten years. Today non-spousal beneficiaries of IRA's are required to take the entire sum within 5 years or begin receiving distributions over the lifetime of the beneficiaries (stretch "IRA" is a term used). Under the new law, beneficiaries would have to take distributions from inherited individual retirement accounts no longer than ten years, increasing the likelihood that withdrawals from traditional IRAs bump heirs into higher tax brackets — thereby making tax-free Roth distributions a valuable prospect.
In addition, reducing taxable income with tax-free Roth IRA distributions may also reduce the amount of taxes that are based on taxable income, such as taxable social security wages, the amount of Medicare B premiums, and other deductions or credits based on level of taxable income.
A simple, but reasonably suitable analogy to demonstrate the main point in evaluating a Roth or traditional IRA is imagining you are planning to drive on a long trip, and your goal is to drive approximately 3,000 miles to see the countryside. You have the option of prepaying for a gas card or paying for gas as you go. Your car holds 15 gallons of gas and the cost of gasoline is $5 per gallon (everywhere). Therefore, the prepaid card will cost you roughly $1,000 (3,000 miles/15 gallon tank x $5 per gallon).
Here is your decision – If you believe gas will be rising in price, then you may prefer paying upfront the $1,000, which will take you the estimated 3,000 miles without costing another penny in gas. Or, if you believe that gas will fall in price, you may prefer to pay as you go and ultimately spend less than $1,000 for gas. So that’s it! The decision to open up a Roth IRA falls on a concept very similar to the prepaid gas card. Based on what you feel about future tax rates and your personal tax situation, you either pay tax now and receive future tax-free earnings, or you wait and pay tax on the full amount when you receive distributions.
The Back-Door Roth IRA
Roth IRA’s, unlike traditional IRA’s, have limitations on contributions depending on certain levels of income earned. A traditional IRA has no income limitations on contributions but deducting the contribution will depend on whether you were covered under an employer-sponsored retirement plan and your income. For a Roth IRA, if a joint couple’s modified Adjusted Gross Income (AGI) is above $193,000, they cannot take advantage of a Roth IRA. However, there exists a strategy available that could allow high-income taxpayers to benefit from the Roth. They can use what is called a “back-door” Roth IRA. Basically, it’s a two-step process:
- Make contribution to a non-deductible traditional IRA, and
- Convert non-deductible traditional IRA (1) to Roth IRA.
There are a few caveats to be aware of, however, that can jeopardize the use of this investment strategy. For instance, if the two steps take place immediately or quickly after one another, the IRS may invoke the “step-transaction doctrine,” and deem the transaction as a high-income taxpayer (otherwise not eligible) making a Roth contribution – a violation of tax rules (a safe period would be six to twelve months). Also, if an individual has multiple IRA’s, the tax conversion cost would include all pre-tax IRA’s, not just the amount converted to Roth (aggregation rule).
The “Mega Back Door Roth IRA is also a consideration for participants in 401(K) plans who exceed income limits to make Roth contributions. The employee would contribute to after-tax 401K plan and then convert that 401(K) account to a Roth IRA. The potential benefit of using the back-door approach with 401(K)’s is the ability to make greater contributions inside a 401(K) plan, therefore, create greater future tax-free savings. But there are also a few caveats with this strategy including the risk of discriminating in favor of highly compensated employees, which could create additional costs. In addition, the contributions to a after-tax 401(K) account must take place after full contributions (max) have been made to regular 401K and Roth accounts.
Conclusion
The primary reason for choosing a Roth is to gain a tax advantage by eliminating future taxes on future distributions. The cost of the strategy is the taxes paid up-front (from cash or other account, but not from the Roth). Therefore, to justify the Roth as a better alternative to the traditional IRA, an investor must recoup that tax amount, and be compensated for the missed investment return on the initial taxes paid. This is done by receiving tax free earnings in the future from the Roth, rather than paying taxes on the earnings from a traditional IRA. But it’s only after the distributions are made years later that we’ll know if the choice was a wise one. But in the right situation, the benefits could be substantial. The longer that you’re able to take distributions from your Roth IRA, the greater chance you’ll have at accumulating annual tax savings that exceed the taxes paid initially (compounded).
If you would like further information on a Roth IRA, or you would like to have an analysis done for you, please contact us. To properly analyze if the Roth is right for you, we would use current tax situation, future income sources, and projected expenses (including goals) to help determine. Please review our website for additional sources of information and services we provide. Thank you.