Deciding on a Roth or Traditional IRA Is All About Strategy and Timing

— -- This is a tale of two types of individual retirement accounts: Traditional IRAs and Roth IRAs. Regarding taxes, the two are direct opposites -- a critical difference that calls for fundamentally different strategies to use either to your best advantage.

The money you put into a traditional IRA, and the growth of it through returns on investments and compounding, is tax-deferred. You don’t have to pay taxes on this money until you remove it. Then, both your contributions and your investment gains are subject to income tax. Beginning at age 59 1/2, you can withdraw money without penalty, but you pay must ordinary income tax on these amounts. If you withdraw money before the age of 59 1/2, you must pay the tax plus a hurtful 10 percent penalty.

With a Roth IRA, you pay tax on the income you use to make contributions to your account in the years that you make them, so no tax is due when you take money out. To avoid the 10 percent penalty, you can’t take any withdrawals before you’re 59 1/2 and this money must have been in your account for at least five years. Eligibility for Roths is based on income levels—see this IRS guide for more details. The maximum you can put into either type of IRA annually is $5,500, or $6,500 if you are 50 or older. These limits apply to total contributions to both types.

Roths have some distinct advantages. Unlike traditional IRAs, Roths don’t force holders to start taking money out after the age of 70 1/2. You can keep investing as long as you live. And you can bequeath Roth accounts as a tax-free nest egg to your children, who can keep them over their lifetimes. This isn’t allowed with traditional IRAs.

On the negative side, if you’re in a low tax bracket during retirement, you’re not saving much by having a Roth, and you will have given up the tremendous benefit of reducing your tax bills during your working years.

A common situation calling for a Roth is when people expect to be earning far more later in life. As most people earn more money in middle-age than they do when just starting out, this strategy often makes sense. This is an argument for retirement-minded 20- and 30-somethings who expect their incomes to grow to choose a Roth. Yet many people struggle financially in their 20s and don’t start investing until much later. If these people start investing in a Roth in their highest earning years, they don’t get the tax deduction on contributions when they need it the most.

If you have both types of IRAs, you can take withdrawals from each tactically. Let’s say you’ve had your Roth for five years or more and you’re 59 1/2 or older. You’re still working, and you want to take out this money tax-free for a trip, so you Roth money for this. During retirement, when you’re in a lower tax bracket, you can pay expenses by taking post-tax money out of your traditional IRA.

Owning one of each can be advantageous for people whose incomes vary widely from one year to the next, including business owners. These people can take money out of Roths in years of high earnings -- when withdrawals from their traditional IRA would cause tax pain. Instead, they do this in low-income years, when their tax rates are lower.

You can convert a traditional IRA a Roth. Most people do this to save on taxes. Though all ensuing contributions to your Roth will be post-tax, you must pay taxes on traditional IRA money that you move into your Roth, as this money has never been taxed.

One clear path is to time your conversion for a low tax year to minimize the hit. If your income is basically the same every year, it may be advisable to create a Roth and gradually move money to it from their traditional IRAs, over several years, to minimize bracket creep.

Roth conversions can complicate retirement scenarios. By converting while drawing Social Security benefits, some people unwittingly create a deadly financial cocktail. Conversions can increase the amount of Social Security benefits that are taxed, and can also trigger a surcharge on some Medicare benefits. To avoid this and to assure tax-free access upon retiring, it’s best to complete conversions five years before retiring.

As with most financial choices, whether a Roth is a good choice over a traditional IRA, and whether converting to a Roth is a good idea, depends on your particular circumstances and goals.

Any opinions expressed in this column are solely those of the authors.

Jamie Cornehlsen and Ted Schwartz are advisors with Capstone Investment Financial Group in Colorado Springs, Colo. Cornehlsen is also president of Dunn Warren Investment Advisors in Greenwood Village, Colo. A Certified Financial Planner®, Schwartz advises individuals and endowments. He holds a B.A. from Duke University and an M.A. from Oregon State University. He can be reached at ted@capstoneinvest.com. Cornehlsen, a Chartered Financial Analyst®, advises business owners and employees on retirement plans. He holds a B.A. from the University of Colorado and an M.B.A. from the William E. Simon School of Business at the University of Rochester. He can be reached at jcornehlsen@capstoneinvest.com.