Many individuals must decide whether it is better to contribute to a Roth IRA or a traditional deductible IRA. Generally, the taxpayers faced with this decision (i.e., those eligible to make contributions to either a Roth IRA or a deductible IRA) are the following:

a) Married taxpayers (or a married spouse) who are either (1) not covered by an employer-sponsored retirement plan and whose modified AGI is less than $214,000 or (2) covered by an employer-sponsored plan and whose modified AGI is less than $129,000 for 2022; or (1) not covered by an employer-sponsored retirement plan and whose modified AGI is less than $228,000 or (2) covered by an employer-sponsored plan and whose modified AGI is less than $136,000 for 2023.

b) Single or head-of-household taxpayers who are either (1) not covered by an employer-sponsored retirement plan and whose modified AGI is less than $144,000 or (2) covered by an employer-sponsored plan and whose modified AGI is less than $78,000 for 2022; or (1) not covered by an employer-sponsored retirement plan and whose modified AGI is less than $153,000 or (2) covered by an employer-sponsored plan and whose modified AGI is less than $83,000 for 2023.

Modified AGI and IRA Contributions

When available, contributions to designated Roth accounts (DRAs) or Roth 401(k) accounts are not limited by an individual's modified AGI or lower IRA limits. High-income individuals can contribute to a DRA even when their income exceeds the modified AGI limit for a Roth IRA. The decision depends on the client's unique tax and financial situation. One should make this decision only after considering such factors as the person's age, current income tax situation, net worth, and expected post-retirement tax situation. As with most tax planning alternatives, the planner should calculate the numbers for all other options before deciding on a particular tax planning strategy. Many commercial software calculators are available for comparing Roth IRAs to traditional deductible IRAs. Some may consider different factors than others, so planners must consider the variables applicable to their client's situation.

Suppose a taxpayer can contribute to a 401(k) plan where the employer matches employee contributions. In that case, it generally pays for the taxpayer to make 401(k) contributions to the extent needed to get a full employer match before putting money into an IRA. DRAs provide another option for saving with many of the same advantages as a Roth IRA and simultaneously obtaining the employer match. The designated Roth option is available only if an employer sponsoring a 401(k) plan chooses to make it available.

Generally, helping a client decide will highlight the critical differences between Roth IRAs, DRAs, and deductible IRAs. In this regard, Roth IRAs and traditional IRAs are mirror images. Contributions to a traditional IRA are deductible, but the funds (contributions and earnings) are taxable when withdrawn. Roth IRA contributions are nondeductible, but a person can withdraw qualifying distributions of contributions and earnings tax-free. Thus, the tax benefits of deductible IRAs are "frontloaded," while the tax benefits of Roth IRAs are "backloaded." The tax benefits of the designated Roth accounts are generally the same as those of Roth IRAs, except that the mandatory distribution rules apply, and the contribution limits are increased significantly for DRAs. See Appendix 5A for a chart summarizing the key differences between traditional IRAs, Roth IRAs, and DRAs.

Advantages of a Roth IRA or a Designated Roth Account

The advantages of a Roth IRA are: making tax-free withdrawals (if the requirements are satisfied) and no mandatory distribution rules at age 73 (or 72 if the recipient's birthday was before 2023; or 75 if the recipient's birthday was before 2033). Planning for Distributions discusses IRA distribution rules in greater detail.

The same advantages apply to designated Roth accounts (DRAs), except that they are subject to the same mandatory distribution rules as the 401(k) deferral accounts as long as the account is part of a 401(k) plan. See paragraph 501.12 for one way to avoid required minimum distributions (RMDs).
Roth IRA distributions are taxable only in limited circumstances. Qualified distributions are entirely free of tax. Even if the taxpayer receives a nonqualified distribution from a Roth IRA, only the earnings are taxed. Furthermore, earnings are distributed after contributions. (Appendix 6C summarizes the ordering rules for Roth IRA distributions.) Therefore, taxpayers can withdraw an amount up to the cumulative contributions at any time, tax-free and penalty-free. However, earnings included in nonqualified distributions are subject to the 10% early distribution penalty unless the individual has met the five-year and age 591 ⁄2 requirements (see section 603) or the withdrawal qualifies for an exception to the 10% penalty (see section 606).

Unlike traditional IRAs, Roth IRAs are not subject to the minimum distribution rules during the taxpayer's lifetime [IRC Sec. 408A(c)(5)]. (See section 607.) Taxpayers can time their lifetime distributions as they see fit (e.g., to meet unplanned cash flow needs). Thus, taxpayers who do not expect to use IRA funds to pay their living expenses will presumably find that a Roth IRA is a superior wealth maximization vehicle to a traditional IRA because of continued tax-free growth until the account owner's death. The minimum distribution requirement is not subject to the 3.8% NIIT, but including taxable RMDs can increase the owner's exposure to the 3.8% NIIT (see paragraph 602.3).

The elimination of the RMD, coupled with an ability to spread post-death distributions over the life expectancy of an eligible designated beneficiary, offers flexibility and unique planning opportunities. 501.11Note: The 2019 SECURE Act changes the distribution period to a non-spouse designated beneficiary from a lifetime distribution period to a 10-year maximum distribution period (2019 SECURE Act Section 401). Under this change, the IRA must distribute all amounts held by the end of the 10th calendar year following the year of the IRA owner's death. Exceptions to the 10-year maximum distribution period include distributions to (a) disabled or chronically ill beneficiaries, (b) a child of the participant or IRA owner who has not reached the age of majority, and (c) a beneficiary who is no more than ten years younger than the deceased participant or IRA owner. This change is effective for distributions concerning IRA owners who die after December 31, 2019.

DRAs are subject to the mandatory distribution rules at the applicable age listed in Exhibit 607-1. Therefore, the ability to roll the funds to a Roth IRA provides an opportunity to avoid taking mandatory distributions. However, mandatory distributions from the Roth IRA are required after the owner's death. Individuals should consider opening a Roth IRA before or soon after contributing to a DRA to be prepared for a future rollover to avoid the minimum distribution rules or to be able to make qualified distributions from the Roth IRA at the earliest date. The five-tax-year period for qualified distributions from a DRA and a Roth IRA is determined independently.

Factors Favoring a Roth IRA or Designated Roth Account

Consider the following general principles when evaluating the benefits of a Roth IRA or a designated Roth account (DRA) compared to a traditional deductible IRA.

a) Generally, the longer the period the funds will be invested, the more beneficial the deferral and tax-free distribution advantages of the Roth IRA. In the long term, taxpayers will accumulate more after-tax income under a Roth IRA than a traditional IRA. The shorter the fund's investment period, the more beneficial the immediate tax savings advantage of the deductible IRA. Roth IRAs are desirable for young taxpayers who can take advantage of a long tax-free compounding period.

b) A taxpayer who expects to be in a higher tax bracket at retirement than today would favor a Roth IRA with its tax-free withdrawals at retirement, while an individual who intends to be in a lower tax bracket at retirement would prefer a traditional IRA with its current deduction at today's higher tax rate.

c) A Roth IRA generally is preferable for taxpayers currently in a low tax bracket who anticipate remaining so. They will realize little or no immediate tax savings from contributing to a deductible IRA.

d) Because Roth IRA withdrawals come first from contributions (not taxed and not subject to the 10% early distribution penalty when withdrawn), taxpayers can withdraw contributions from a Roth IRA tax-free and penalty-free at any time, regardless of fund usage. Withdrawal is true even if the five-year waiting period has not expired and the taxpayer is not yet age 59½. (See section 603.) Thus, Roth IRAs can be helpful for taxpayers who may need their original contributions (for whatever purpose) before retirement.

e) If a DRA is available, it should be utilized to allow the taxpayer to receive any available match from the employer.

Example: Using a Roth IRA to Fund Education Expenses

Bruce, age 55, opened a Roth IRA in 2015 and will contribute the maximum amount each year. His son, Brandon, will begin college in 2027. Bruce intends to withdraw funds from the Roth IRA in 2026 to help fund Brandon's education. Because Bruce will be over 59½ and opened the Roth IRA at least five years before that time, the withdrawal of contributions and the related earnings will be tax-free.

Effect of Marginal Tax Rate on Retirement

If the taxpayer's marginal tax rate is higher in retirement than today, the Roth IRA is more likely to be a better choice than a deductible IRA. Even a slight increase in the tax rates between the money contribution time and withdrawal is enough to tilt the scales in favor of the Roth IRA.

Knowing the future tax rate an individual will be subject to retirement makes it easier to answer whether they should consider making Roth IRA contributions or a Roth conversion. If the individual's marginal rate were higher at retirement than now, the individual should consider saving in a Roth account. Increases in future tax rates can come from at least two sources. A Taxpayer can have more income in the future versus the current tax year; thus, a higher marginal tax rate or tax rates could be higher. State income taxes could also be a factor if the taxpayer anticipates moving from a low-tax state to a higher one.

Conversely, suppose a significant drop in tax rates is expected (either because of the taxpayer's changing circumstances or because of an overall rate decrease). In that case, the advantages of a Roth IRA are reduced or eliminated, and the deductible IRA may be a better choice. Example Impact of marginal tax rates.

Tom Smith, age 60, has $2,000 of income to invest and is considering either a Roth IRA or a deductible IRA. Tom is in a combined 28% federal and state tax bracket. If he contributes $2,000 to a Roth IRA, $560 of tax (28% of $2,000) will be due on the income. Tom's tax planner put together different scenarios to determine whether a Roth IRA or deductible IRA is more advantageous. The sole difference in the following scenarios is Tom's marginal tax rate at the time of the contribution versus when funds are taken out of the IRA. (Because Tom is at least 59½ before taking an IRA distribution, the 10% early distribution penalty tax does not apply.)

Scenario 1: Marginal Rate Stays the Same.

In the first scenario, Tom's marginal rate stays the same. Tom would only have $1,440 to invest using a Roth IRA after paying $560 of income tax on the $2,000 earnings. After five years, this $1,440 grows to $2,319, assuming a 10% annual return. At that point, Tom could withdraw the funds without additional tax liability. The total of $2,000 can be invested in a traditional IRA because no income tax is due on the $2,000 of earnings. Again assuming a 10% annual return, the $2,000 contribution will grow to $3,221 in five years. However, if Tom withdraws the entire balance at that point, a tax of $902 ($3,221 × 28%) is due, leaving an after-tax balance of $2,319. The balance is the same amount Tom would have with a Roth IRA. Thus, when the tax brackets remain the same, and the upfront tax costs reduce the contribution to the Roth IRA, it makes no difference which type of IRA a person chooses. However, compare this to the results shown in the Exhibit, where the upfront cost of the income tax due does not reduce a $2,000 annual contribution to a Roth IRA.

Scenario 2: Marginal Rate Increases.

What if Tom's marginal rate increases? Taxpayers assume automatically that their tax rate will drop when they retire. It may even increase (because their income does not significantly decrease when they retire, or because Congress raises the tax rates or some combination of both). This scenario assumes a 31% (instead of 28%) marginal tax rate of withdrawn funds and no changes for the Roth IRA - it still increases to $2,448 after five years. When using a traditional IRA, the total $2,000 contribution will grow to $3,221 in five years, as before, assuming a 10% growth rate. However, if Tom withdraws the entire balance at that point, a tax of $999 ($3,221 × 31%) is due, leaving an after-tax balance of $2,222. Therefore, the Roth IRA generates $97 ($2,319 − $2,222) of additional after-tax income. Under this scenario, the Roth IRA is the better choice; as illustrated, even a slight increase in the tax rates between the time the investment and withdrawal of the money make enough difference to tip the scales in favor of the Roth IRA.

Scenario 3: Marginal Rate Decreases.

What if Tom's marginal tax rate drops from 28% (when the contribution is made) to 18% (five years later when the accumulated funds are withdrawn)? Using a Roth IRA, the results would be the same as in the previous scenarios. Tom would only have $1,440 to invest after paying $560 of income tax on the $2,000 of earnings. After five years, this $1,440 grows to $2,319, assuming a 10% annual return. At that point, Tom could withdraw the funds without additional tax liability.

When using a traditional IRA, $2,000 can be invested because no income tax is due on the $2,000 of earnings. Again assuming a 10% annual return, the $2,000 contribution will grow to $3,221 in five years. However, if Tom withdraws the entire balance at that point, a tax of $580 ($3,221 × 18%) is due, leaving an after-tax balance of $2,641. Therefore, the deductible IRA generates $322 ($2,641 − $2,319) of additional after-tax income. This $322 difference represents an almost 14% better return over the five years for the deductible IRA.

Note: The previous scenarios are based on five years, but the results would be more dramatic as the period gets longer and additional IRA contributions are made. Also, any positive impact on AGI-sensitive deductions resulting from the deductible IRA and the negative effect of distributions from a deductible IRA have been ignored.

Taxpayers in the lowest and the highest tax brackets may find the Roth IRA more beneficial for different reasons. Taxpayers in the lowest bracket may find that traditional IRA distributions will cause more of their social security benefits to become taxable. Taxpayers in the highest tax bracket may find that conventional IRA distributions cause them to exceed the AGI threshold that caused them to become subject to the 3.8% net investment income tax ($250,000 for married filing joint, $125,000 for married filing separately, and $200,000 for all other filing statuses).

Using these assumptions, the Roth IRA generates the most wealth even before considering the effect of the favorable distribution rules (i.e., no minimum required distribution until after the owner's death and faster basis recovery rules for any taxable distributions) and estate tax rules. Although a more significant amount can be invested each year using a traditional IRA (since the tax saving is available for investing), paying current tax on the "outside account" reduces the effect of investing additional funds.

Designated Roth Accounts Provide for Higher Contributions

Roth IRA and traditional IRA contributions for 2022 are limited to $6,000 ($7,000 if age 50 or over by December 31 of the applicable tax year), and for 2023 are limited to $6,500 ($7,500 if age 50 or over by December 31 of the applicable tax year). Designated Roth accounts (DRAs) are subject to the same limits that apply to 401(k) elective deferrals ($20,500 for 2022; $27,000 if age 50 or over by December 31, 2022; $22,500 for 2023; $30,000 if age 50 or over by December 31, 2023). The nondiscrimination rules may further limit the limit for highly compensated employees.