Risk & You 2011 - Special Report

Roth or Regular IRA? Only Time May Tell

Janet Whitman,|Special to CNBC.com

Opting to put some of your retirement nest egg into a might come down to how you feel about politicians.

Personal income taxes are sure to rise over the coming decades, as lawmakers grapple with the country’s massive budget deficit. That makes a Roth — a retirement fund made with after-tax money that isn’t taxed again when withdrawn for retirement or passed on to your heirs — seem a great bet.

Why take a bigger tax hit down the road when you can pay now at a lower tax rate? Not so fast, tax experts and financial advisors say.

Roth IRA Changes Coming?

Given the track record of politicians in other investment and retirement matters, there’s a chance Roth IRAs won’t retain their special status that allows them to grow tax-free, say personal finance experts.

A grab-back could result in a sizable hit for the hundreds of thousands of retirement savers who last year converted their traditional IRAs to Roth IRAs after the federal government removed the $100,000 income cap that limited the availability of the investment vehicle.

“Pardon my cynicism, but my fear is that some future Congress will put an excise tax on Roth IRAs to raise money,” says Warren Ward, a financial planner in Columbus, Ind. “What they’re doing now is kicking the can down the road. They might say, ‘Remember that deal we made 10 years ago? There’s a huge amount of money there. Let’s go after that.’ ”

Financial planners point to the Reagan administration’s move in the early 1980s to put a tax on Social Security checks as an example of what could be ahead for Roth IRAs.

Retirement Diversification

That kind of uncertainty over the future tax environment can also make Roth IRAs an attractive investment, says Christopher Cordaro, a wealth manager at RegentAtlantic Capital in a Morristown, N.J.

“From a planning perspective, if you could have two pots of money — a Roth that you’ve already paid taxes on and another pot that you haven’t — it gives you the greatest flexibility,” Cordaro says. “You basically have diversification. Particularly if you aren’t sure what the tax code is going to be in any given year and what your overall income is going to be, it’s good to have greater flexibility."

Cordaro explains the appeal of Roth IRAs to his clients by likening traditional IRAs to a big home mortgage.

“Let’s say you have a million-dollar investment account and a million-dollar house,” he says. “If you have a $350,000 mortgage, you owe the bank that liability. Think of an IRA the same way. It’s like a $350,000 tax liability. Sometimes it’s better to pay off that liability sooner."

Roth IRAs Benefit Younger Workers

Roth IRAs are typically best suited for younger people — say 25 years old — as they are getting into the workforce and have relatively low tax rates .

Bernhard Lang | Getty Images

“The longer you have to invest the money, the better,” says Cordaro. “I have three teenage daughters and I’m setting up Roths for them as soon as they have taxable income. The $3,000 that my daughter earned will never have tax on it again and it has potentially 60 or 70 years of tax-free accumulation,” he said. The chance that Roths won’t have such favorable tax treatment by the time his daughters retire is worth the risk.

Other people who make good candidates for Roth IRAs are those who don’t need the money.

“Their goal might be to have an asset to benefit their children,” says Beth Gamel, co-founder of Pillar Financial Advisors in Waltham, Mass. “The payback for them is they can leave the asset to their children and that it would never be taxed."

If it comes down to a choice between a company-sponsored plan where the employer offers to match an employee’s contribution, it’s always better to take the free money, says Ward, who caters mainly to middle-income clients in Indiana.

“One thing I learned 20 some years ago when I first started out as a stock broker is the saying, Don’t let the tail wag the dog,” he says. “You should make good investment decisions first. Don’t let the tax consequences be the main reason.”