In 1997, Congress created the Roth IRA, a retirement investment vehicle funded with after-tax dollars that grow and generally may be withdrawn tax free after age 59 ½. The intent of the Roth IRA was to incentivize middle-class wage earners to save for retirement, as indicated by the accompanying income-eligibility limits based on modified adjusted gross income, or MAGI (see Table 1). Since then, Congress has expanded the opportunities for tax-free retirement income to higher income earners. EGTRRA 2001 authorized employers to allow Roth contributions to 401(k) and 403(b) plans without any income eligibility requirements effective 2006. Furthermore, the Deficit Reduction Act of 2005 removed the income limit (MAGI of $100,000 in 2009) for conversions from deductible and nondeductible IRAs to Roth IRAs effective January 1, 2010.

Regardless of the form or strategy, the decision of using a Roth account revolves around the timing and application of income taxes. The Roth option involves paying taxes on contributions now but excluding the taxation of earnings when distributions are taken at retirement. On the other hand, traditional qualified retirement plans involve deferring taxation on contributions and paying taxes on contributions and earnings when they are withdrawn. Obviously, the advisor will need to evaluate each client’s individual situation. The purpose of this article is to raise some important issues to help clients make this decision.

The guiding principle is that clients should definitely consider an available Roth strategy if their marginal tax rate is projected to be higher during retirement than during the years they make contributions. Here are two examples of situations for which higher tax rates are a strong possibility.

First, with the current level of government spending (federal, state, and local) and federal debt, higher taxes are imminent, especially for those with higher incomes. For instance, The Obama Administration has indicated that it will increase taxes for joint filers with incomes over $250,000 and single filers over $200,000.¹  Thus, Roth accounts are an excellent strategy for those in the two highest tax brackets before tax rate changes occur.

Second, married couples have a unique exposure to a higher marginal tax bracket in retirement. Should they divorce or one of them die prior to or during retirement, assuming no subsequent marriage and no dependent children, their tax filing status would be single throughout retirement. Consequently, the single filer qualifies for half the standard deduction (assuming no itemization) and personal exemptions than a joint-filing couple. More importantly, the income bracket for each marginal tax rate, except for the 35 percent tax rate, is lower for a single filer than for a joint filer (see Table 2). Thus, more income may be exposed to the higher tax bracket or worse, a higher tax rate may apply to some of it.

Example: Steve and June file a joint return. Their total income from taxable sources is $85,000. Without any deductions other than the standard deduction and exemptions, this couple would have a taxable income of $66,300 ($85,000 – $11,400 standard deduction – $7,300 for exemptions on each taxpayer). Steve and June are in the 15 percent tax bracket.

Assume that Steve dies and June never remarries. She is now 65. Her retirement income is $60,450 (assuming 2009 dollars and that this amount reflects only the amount of Social Security income that is taxable). Assume that her exemptions and standard deductions equal $10,450 (her standard deduction would be $5,700 plus $4,750 in exemptions since she is 65). June’s taxable income is $50,000. Using 2009 tax tables, $16,050 of that income will be taxed at 25 percent.

Obviously, no one currently working knows for sure what his or her tax situation will be when he or she retires, especially those for whom retirement is many years in the future. As such, there are some ancillary issues to evaluate. One of these issues is the effect that taxable income has on Social Security benefits. If a couple’s provisional income (which adds back to one’s adjusted gross income certain tax preferences such as interest from some types of municipal bonds) plus 50 percent of Social Security benefits exceeds $32,000 ($25,000 for single filers), then a percentage of Social Security will be taxable. If this amount exceeds $44,000 ($34,000 for single filers), 85 percent of Social Security benefits are taxable.²  Income for a Roth IRA is received income tax free and, unlike municipal bonds, is currently not includible as provisional income.

In addition, Roth accounts give clients greater flexibility in timing and usage of monies. For the Roth IRA, there is no required minimum distribution at age 70½ for the account holder, or his or her surviving spouse. Monies can be saved for use beyond age 70½ and, if not needed, passed generally income tax-free (estate taxes may apply) to heirs. Although the Roth 401(k) and 403(b) plans must follow the required minimum distribution rules applicable to other qualified plans, there is a provision in the tax law that allows a rollover from a Roth 401(k) or 403(b) plan to a Roth IRA. Therefore, Roth accounts may offer some estate planning options not available through other retirement plans.

A final issue is the hedging and diversifying aspect of Roth accounts. Specifically, having a portion of one’s retirement assets in Roth accounts provides a hedge against the risk of higher taxes. With a Roth account clients pay a known income tax liability on a smaller known amount, as opposed to an unknown tax liability on a hopefully much larger unknown amount. That is, investing in Roth accounts diversifies a client’s retirement income to include taxable and tax-free sources, allowing the client to strategically receive tax-free income to avoid moving into a higher tax bracket or exposing more Social Security income to income tax.

The tax-free retirement income available through Roth accounts is something that can benefit many of your clients. Specifically, Roth accounts can result in higher after-tax income and greater flexibility for those clients who may want to avoid required minimum distributions. By examining the issues discussed in this article, you can help your clients to decide whether “to Roth” or not.

_{¹ Chye-Ching Huang, Jason Levitis and James R. Horney, Center on Budget and Policy Priorities, Very Few Small Business Owners Would Face Tax Increases Under President's Budget: Vast Majority Would Benefit from Other Key Proposals, (February 28, 2009), 2.}

_{² These thresholds are currently not indexed for inflation.}