The Only Times You Should use a Roth-style Account

In a couple of recent blog posts (see here and here), I’ve trash-talked the option of using Roth-IRA and Roth-401(k) accounts.

And that trash-talking seems fair given the general inappropriateness of Roth-style accounts for most people.

However, in three or four situations taxpayers probably should use a Roth-style account rather than a traditional 401(k) or traditional IRA account. To be fair, then, let me identify and describe these situations.

People Who Don’t Currently Pay Any (or Much) Income Tax

If someone doesn’t pay income taxes or doesn’t pay much income tax, a Roth-style account probably makes good sense.

The reasoning goes like this: If such a person uses a traditional IRA or 401(k), they don’t get any or much tax savings anyway because they don’t pay any or much tax. And the Roth-style account could save them taxes in the future.

For example, anyone with a below-median-income, a mortgage and children probably doesn’t pay any federal income tax and very possibly doesn’t pay state income tax. This investor should, given the choice, use a Roth-style account rather than a traditional IRA or 401(k).

Another example: If you have school-age children or grandchildren with part-time jobs, because they don’t pay any income taxes typically, a Roth-IRA often makes good sense for them, too. (I’m thinking here that you as a parent or grandparent might want to gift them money which they would use for the Roth account contributions.)

Again, note the logic: If a traditional IRA or 401(k) doesn’t save taxes and in the future a Roth-style account might save taxes, heck, go with the Roth.

That makes sense, right?

People Who Will Probably Always Pay the Top Tax Rate

Okay, so remember that the optimal choice when picking between Roth-style and traditional retirement accounts comes down to the marginal tax rates. And what someone wants to do is “pay the fiddler” when the tax rate is lowest. Usually that’s during retirement.

However if you’re someone who will always pay at the top tax rate, you may as well pay your taxes now by using a Roth-style account. You don’t know for sure that you’ll save income taxes by doing this.

But you will by doing this “lock in” your tax rate in effect, thereby protecting yourself against future tax rate increases. You will also reduce or eliminate the need to take required minimum distributions from your retirement accounts.

Caution: If a flattened tax rate structure ever occurs—and legislators regularly propose this—you do not want to convert or to have already converted to a Roth-style account. Rather, you want to wait for the flattened rates–and then convert.

By the way, you probably don’t need to start thinking you’ll always be in the top tax rate until you have something in excess of $10,000,000 in investments producing investment income something in excess of $500,000 annually.

People Who Want to Tax-diversify

Okay, this is maybe a little far-fetched, but you will sometimes hear pretty smart people talk about using Roth-IRAs and Roth-401(k)s as a way to diversify the tax risks connected to your investments.

As a tax accountant, I am not a fan of trying to guess what Congress will do.

But that said, this tax diversification angle is probably a good idea for people with larger balances. (Say over $2,000,000?)

Who knows what Congress might do in the future with regard to retirement accounts (including both traditional IRA and 401(k) accounts and also Roth-style accounts).

But very possibly, Roth-style accounts might be treated differently in any re-writing of pension tax laws. And if that were the case, you might benefit from having your money sprinkled among a few different types of retirement accounts.

For example, decades ago, tax law levied an excise tax on large six-figure distributions from retirement accounts. If Congress ever reinstituted this excise tax, past implicit political promises to the electorate might stop Congress from applying such a tax to Roth accounts.

People With a Decimated Portfolio—Maybe

So one final category of investor may want to consider using a Roth-style account: someone with a massively beat-up IRA account balance and money outside of tax-deferred accounts to pay for a conversion.

But let me explain with an example.

Suppose that you have a growing $1,000,000 IRA balance and that you also know by the time you retire this money will have doubled. Or even quadrupled.

Further suppose that (perhaps due to some financial system meltdown like the one recently experienced) that the IRA balance declines by half. So, boom, the $1,000,000 balance becomes a $500,000 balance.

In this situation, it’s probably not crazy to consider converting the $500,000 IRA to a Roth-IRA. Yes, you’ll pay a hefty tax rate on this conversion. Perhaps 40% of the $500,000, so $200,000?

But assuming the IRA balance rebounds to $1,000,000 and that it then continues to grow, you may (in effect) lock in your tax bill at a low level due to the temporarily depressed account balance.

Note: People who did this during the Great Recession triggered bear market ended up really well obviously… and though risky what they were betting implicitly was that their 401(k) and IRA accounts really had not been halved in value no matter what the statements from the mutual fund company or their investor adviser said… Rather, these people assumed that the craziness in the capital markets only made it seem that way.