Roth Accounts: Not Only for the Young

Roth IRAs aren’t very old, but they already spawned some rules of thumb. The most common rule of thumb for Roth IRA is that they’re for relatively younger people. Unfortunately, this rule of thumb is the result of some good research that is distorted and misapplied. It’s causing many people to not use Roth IRAs when the vehicles could benefit them and their heirs.

The rule of thumb began from a sensible base. A Roth IRA needs to compound income and gains for a while to make up for paying taxes early. The tax benefits of the Roth IRA (tax-free distributions, no required minimum distributions on the original owner) are back-end loaded, while the tax benefits of a traditional IRA are front-end loaded. But it doesn’t take as long as many people now think for the Roth IRA to pay off, and how long it takes depends on several variables.

When the ability to convert a traditional IRA to a Roth IRA first became available, I did some calculations and estimated that for most people the Roth IRA had to compound for seven to 10 years for a conversion to pay off. Research by others supported this conclusion. The pay off period depends on investment returns, the difference between tax rates at the time of conversion and the time of distributions, how the taxes on the conversion are paid, and other factors.

Rules of thumb distorted this research. I regularly hear from readers that they were told they were too old to consider a Roth IRA. If someone states a conclusion such as that without crunching the numbers for your situation and showing you the payoff period, you should be skeptical. I’ve demonstrated in the past how converting to a Roth IRA can be a great estate planning tool, even for older people.

Fortunately, new research specifically addresses the issue of older Americans and Roth IRAs. Before delving into the research, you should know that Roth 401(k)s now are available through many employers, especially large employers. Workers can choose between a traditional 401(k) and a Roth 401(k). This choice is in addition to the choice between a traditional IRA and Roth IRA. You also have the option to convert a traditional IRA or 401(k) to a Roth version.

The new research concludes that many older Americans should consider Roth accounts instead of traditional IRAs and 401(k)s. This applies to both annual contributions to accounts and conversions of traditional accounts to Roth versions, according to a study by Stuart Ritter of mutual fund firm T. Rowe Price.

Let’s look at a 50-year-old worker who can choose to contribute to either a Roth or traditional 401(k) plan. He contributes $5,000 annually until age 65, and then begins annual withdrawals. He earns a 7% annual return and is in the 28% tax bracket the whole time. At first glance, it appears he’d have the same account balance in each scenario, which would be $38,061 after 30 years, according to Ritter’s assumptions and calculations.

The Roth balance, however, is tax free. The worker or his heirs will benefit from that full amount. The traditional account, however, will be taxed at the 28% rate, leaving the worker or his heirs with only $27,404 to spend. Also, higher distributions have to be taken from the traditional account to have the same after-tax spending money as the Roth version.

The worker could select a traditional 401(k) and invest the income tax savings from his contributions in a brokerage account. But that wouldn’t be enough to match the Roth IRA. That’s because the brokerage account earnings would be taxed, so it wouldn’t compound at 7% annually after taxes.

What if the worker is in a lower tax bracket after retirement? Keep in mind that’s less likely these days with only a few tax brackets. But Ritter’s numbers show that the Roth 401(k) still is a better deal if the worker’s income tax rate drops by as much as 10 percentage points in retirement.

What about an older worker? Ritter’s work shows that the Roth 401(k) is the better deal for workers into their early 60s.

Of course, these are hypothetical scenarios. They might not apply to you. The Roth option could be even better for you, or it could be a bad deal, depending on the particulars of your situation and what you want to assume about retirement tax rates, investment returns, and other factors. The important point is that you shouldn’t let rules of thumb and other people’s experiences or views determine your strategy. Take a look at the data.

A Roth account has important advantages over a traditional account that could increase their advantage to you, despite your age.

With the Roth account, you aren’t required to take RMDs after age 70½. You can let the account compound longer than a traditional retirement account, increasing its benefits, if you have other sources of income.

A Roth account also helps you essentially decide the tax bracket you want to be in during retirement. You’ll have other sources of income you can’t control, such as Social Security, annuities, distributions from mutual funds or stocks, and required distributions from traditional accounts. When those don’t meet your spending needs, you can sell some investments at a long-term capital gains rate of 20% and you can tap the Roth account tax free, maintaining your standard of living while controlling your tax bill and rate.

Also, distributions from Roth accounts don’t help trigger higher Medicare premiums, taxes on Social Security benefits, and other stealth taxes.

Another advantage of having some money in a Roth account is the flexibility. If you have a large one-time spending need (new car, child’s wedding, major home repair), you can take the money from the Roth IRA without pushing yourself into a higher tax bracket or triggering the stealth taxes.

What about conversions of traditional IRAs to Roth IRAs? Are those only for the young or youngish? Not always. In fact, it can make sense for someone to wait until retirement to convert retirement accounts.

Consider that your income might be lower in the first years of retirement than during the working years, so you’ll be in a lower tax bracket. That makes it less expensive to convert an IRA or 401(k).

Also, a conversion is most likely to pay off (or pay off faster) when the taxes on the conversion are paid from other funds instead of using part of the IRA or 401(k) to pay the taxes. Many people are likely to have lower fixed expenses in retirement, so they’re more comfortable tapping other accounts to pay the taxes. You also might have generated some cash from the sale of your home or other pre-retirement transactions.

You might move to a no-income-tax or lower-income-tax state in retirement. The converted amount is taxed by both the state and federal governments. So, it is less expensive if you’ve moved to a state with lower taxes.

These factors will make it cheaper or easier to pay for a conversion to a Roth account, and that will reduce the time the Roth account has to compound before the conversion pays off.

We’ve covered some specific guidance and examples in this discussion. But those shouldn’t be your main focus. The main point is that there are variables involved, and what is best for one person on this issue isn’t best for another. You need to consider the variables in your case and run the numbers or have a financial advisor run them for you. Rules of thumb aren’t the way to make these important decisions. Also, because things change you have to reconsider the decision regularly. Not converting might be the right decision this year, but circumstances could change next year or the year after.

In the past we discussed the factors to consider before making a conversion decision. You can find these discussions in the IRA Watch section of the Archive on the members’ section of the Retirement Watch web site. They also are in my book, The New Rules of Retirement. There also are numerous calculators on the Internet to help with the decision. There’s a spreadsheet I put together available for $20 through our web site at