Rethinking Retirement Accounts: Why a Roth IRA Might Not Always Be Best

The premise seems compelling enough. Forego a tax break that may or may not do you much good right now in exchange for tax-free withdrawals in the future -- when your tax rates might be higher. Although nobody knows for sure what the future holds, that's the higher-odds/lower-risk bet most people are making.

Except, Roth retirement accounts' tax-free distributions in retirement aren't necessarily always the right fit. It's possible you'd still be better served by making tax-deductible contributions to an IRA now and paying whatever taxes come due then.

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Here's a closer look at when and why the non-Roth option might make more sense for you.

Roth IRA versus regular

If you're not familiar with the ins and outs of either, here's the deal.

Traditional IRAs -- sometimes called contributory IRAs -- allow you to make yearly tax-deductible contributions to them. Investments made with this money are also allowed to grow tax-free, whether that be through dividends, capital appreciation, or any other form of gain. This money is only taxed (as ordinary income) if and when it's withdrawn from the retirement account.

Roth IRAs work the other way around. While contributions to a Roth retirement account don't reduce your taxable income for the year in which they're deposited, this money is also allowed to grow tax-free, and comes out of these accounts without creating any tax liability. Indeed, since the IRS has nothing to gain from these withdrawals, the agency doesn't even force you to take distributions from Roth IRAs. That's not so with ordinary contributory individual retirement accounts, which of course are subject to required minimum distributions once you turn 73 years old.

Just keep in mind that -- unlike traditional IRAs -- there are income-based limits to Roth IRA contributions.

On balance it doesn't seem to matter much either way. All other things being equal (and assuming you're investing your tax-savings effectively whenever you realize them), paying taxes now or paying taxes then should ultimately leave you with the same amount of spendable cash in retirement. And to be fair, for plenty of people that is the case.

There are some scenarios, however, in which a Roth IRA makes less financial sense than a regular individual retirement account funded with tax-deductible contributions. And one scenario stands out among them all.

When not to use a Roth IRA

Cutting straight to the chase, most investors are best served by paying their IRA-related income taxes when their effective income tax rates are likely to be at their lowest. For example, if you're confident you're earning more in work-based wages now than you'll be collecting in retirement income later in life, your potential tax liability is at its highest right now. Contributing to an ordinary IRA will lower your current taxable income, or more to the point, will postpone the taxability of some of this income -- as well as the investments made with it -- until you retire and you're in a lower tax bracket.

Conversely, if you've got reason to believe that your retirement income will be greater than your current work-based income (perhaps you have a seven-figure IRA, for example), you'll want to minimize your tax liability then even if it means not making tax-deductible contributions now. In this scenario a Roth IRA likely offers you an advantage.

For most people, of course, the former is the more likely scenario.

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That's not the only noteworthy scenario in which a Roth IRA might not be ideal, however. If you're going to need to access the money in this account before you turn 59 1/2 and if your account is going to be opened and initially funded for less than five full years, a Roth may not make the most sense. See, although there are some exceptions (like medical bills or the purchase of your first home), if you aren't going to be able to meet both criteria, withdrawals could be subject to penalization or taxation or both.

Withdrawing money from an ordinary IRA before turning 59 1/2 also incurs a penalty, by the way, on top of the taxation that was always going to be paid anyway. At least there's no five-year minimum waiting period, though.

Given this age-based limitation, it's possible you'd be better off not making contributions to any kind of IRA and instead leaving this money invested in an ordinary brokerage account. It may be taxable every year, but at least it's also flexible.

Of course, you've also always got the option of funding a traditional IRA with tax-deductible contributions and then converting some or all of this individual retirement account into a Roth at a point in time of your choosing in the future.

This is a taxable event, and as such could prove expensive if completed in one shot. But this choice allows you to have your cake and eat it too, with no penalty or additional taxation should you decide later in life that you'd rather have a Roth IRA. You can even pay the taxes on these conversions with money found outside of your retirement accounts. Just bear in mind that you'll still need to be at least 59 1/2 to make penalty-free withdrawals from a converted Roth, and that the five-year taxation waiting period on the withdrawal of any gains (be sure to keep good records!) will possibly still apply beginning the year the conversion was completed.

Nevertheless, this flexibility alone is reason enough to not bother with a Roth until you've got more clarity regarding your financial future. Visit here to learn more about Roth conversions.

Crunch your best-guess numbers, and re-crunch them later

Figuring out which individual retirement account works best for you is admittedly easier said than done. Everyone knows their current financial situation. What may not be nearly as clear, however, is where you'll stand in the future. This exercise will require a bit of well-reasoned and honest conjecture, including about future tax rates. If you're in your 30s or 40s, this could prove particularly difficult to do.

Still, to the extent it's possible, making the best possible projections of your retirement income is time well spent. If you're disciplined enough to invest whatever tax savings you achieve when you achieve them you could ultimately lower your tax bill. The savings could be worth thousands of dollars per year, in fact, for most typical households that manage these not-so-little details.

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