Understanding the Roth Difference

The Roth IRA was established by the Taxpayer Relief Act of 1997 and named for its chief legislative sponsor, Senator William Roth of Delaware.

The general thinking is that the younger you are the more a Roth IRA (or Roth 401(k) plan) will be to your advantage versus a Traditional IRA or Traditional 401(k) plan. And for many individuals this thinking is correct, but not for everyone.

In order to determine your best retirement savings option, you need to understand the real differences between a Traditional and a Roth retirement savings plan. Then you'll be in a position to make the best choice for yourself.

The most obvious difference between the Traditional IRA and a Roth IRA is the timing of the tax deduction/taxability of your contribution. With a Traditional IRA plan, you may receive a tax deduction equal to your contribution, depending on your household income. Then when you retire and begin to withdraw those contributions out of the Traditional IRA plan, they are 100 percent taxable as ordinary income.

With a Roth plan, you do not receive a current tax deduction in the year you make your contribution. However, at retirement time when you withdraw that contribution, the withdrawal is tax-free and not included in your taxable income. So from a contribution point of view, it's merely a timing difference.

Here's where you need your crystal ball. You need to estimate what your tax rate will be at retirement time when you begin your IRA withdrawals. If your tax rate will be greater than it is now, the Roth plan will be more advantageous to you. If however, you are in a very high tax bracket now and anticipate being in a very low tax bracket during retirement, this argues for the Traditional IRA plan.

There is however one other extremely important difference between the Traditional and Roth plans. In the Traditional plan, all of the tax-deferred earnings become taxable as ordinary income upon withdrawal from the plan.

In the Roth plan, all of the earnings within the plan can be withdrawn tax free. This is really the beauty of the Roth plan. It's also why younger individuals tend to benefit more because theoretically, there will be more earnings within the plan at retirement time.

And while for 2014 the contribution limits are the same for the Traditional as well as the Roth IRA, (taxable compensation up to $5,500 with an additional $1,000 catch-up provision for the plan owner's age 50 and over), there are income limits that prevent many wealthy investors from contributing to a Roth IRA.

Having said that, a few years back (in 2010) the government lifted the income restrictions on who is eligible to convert a Traditional IRAs into a Roth IRA. So now everyone can convert a traditional IRA into a Roth IRA.

However, income tax must be paid at ordinary income tax rates in the year of conversion based on 100 percent of the monies converted. It is generally not recommended to convert to a Roth IRA if you need to use other IRA monies to pay the tax due because of the conversion.

Would an elderly person ever want to convert his or her Traditional IRA to a Roth IRA? This may make sense even for an elderly person if they know that their estate will be subject to estate taxes. By converting to a Roth IRA and paying taxes in the year of conversion, they are reducing their taxable estate and their IRA will pass to their beneficiaries as a tax-free asset.

One other advantage to the Roth IRA, is that there are no required minimum distributions at age 70 1/2 as there are with the Traditional IRA. So it's possible to stretch a Roth IRA further than a Traditional IRA.

If you are considering either utilizing a Roth IRA or converting a Traditional IRA to a Roth IRA, you would be well advised to get some competent tax advice from a qualified CPA or qualified financial planner to make sure that what you are about to do makes sense. This is an area of the tax law where you probably don't want to go it alone. Get some good advice.

Terrance R. Gaertner, CPA and CFP, MS is president of Chicago Financial Advisors.  He is a member of The Financial Planning Association.  He has earned a Master of Science degree in Financial Services with a concentration in Retirement Planning.  You can reach him at 847-825-9700 or 900 South Knight Avenue, Park Ridge, IL 60068.