For many people, the decision to invest in a Roth IRA versus a traditional IRA is a bet that their marginal income tax bracket will be higher in their retirement years, when they start taking distributions out of the account, than it is now. This is particularly true for younger workers, who are not yet in their peak earning years. But it could also be true for older workers, as well, if they believe that Congress will effectively raise income tax rates - or lower the ranges affected by the current tax brackets - during the workers' lifetimes.
Taxation of IRAs
First, let's review how traditional and Roth IRAs are taxed. Traditional IRAs allow the investor to take an above the line adjustment to income, effectively reducing taxable income. Investors don't have to itemize to claim this benefit and it is not subject to the 2 percent of income threshold that affects itemized deductions. Assets in a traditional IRA grow tax deferred until they are withdrawn as income in retirement. By April 15 of the year after the year in which the investor turns age 70 1/2, the investor must begin taking distributions over the remainder of his life expectancy, or faster. Roth IRAs do not offer a first year adjustment to income, but grow tax-free as long as the investor lives, provided the money stays in the account at least five years. There are no required minimum distributions.
Marginal Income Tax Brackets
Your marginal income tax bracket is the bracket that applies to the last dollar you earned during the year. The U.S. income tax system is progressive, meaning that the first dollars you earn each year are taxed at a lower rate than the last dollars. For single filers, your income tax rate is zero on the first $5,700 you earn in 2011 (the standard deduction), and only 10 percent on the next $8,500. Your rate is 15 percent on everything after that point up until you earn $34,500, and 25 percent from there until you earn $83,600. After that point, your marginal bracket is 28 percent up $174,400. It is 33 percent from that point to an income of $379,150. If you earn more than that amount, after deductions and credits, your marginal income tax rate is 35 percent. Married couples filing jointly have higher income thresholds, but the same brackets. However, if Congress doesn't act to extend these tax rates into the future, they will revert to a higher tax rate, capping at 39.6.
If you believe your taxable income will not be significantly higher in your retirement years than it is now, but that Congress will raise income tax rates, then you may be better off in a Roth IRA, all things being equal. Likewise, if you believe your income will be significantly higher in retirement than it is currently, you may want to consider a Roth, if you qualify, or consider converting to a Roth from a 401(k). However, if you believe your income is higher now than it will be in retirement, consider taking the current year adjustment to income by using the Roth IRA. If you have no strong feelings either way, consider diversifying by placing some money into both kinds of accounts - a strategy called "tax diversification."
If you are concerned about preserving assets to pass on to your heirs and avoiding the estate tax, then you may want to consider converting IRA assets to Roth IRA assets. By converting and paying income taxes on the amount you convert, you move money out of your estate, where it could eventually be subject to taxes as high as 35 percent on assets over $5 million.