Everywhere you turn these days, you're being told that the Roth IRA is the second coming of the 401(k) and that anyone who contributes to an IRA should choose the Roth. More dangerously, the general advice seems to be that you should convert existing IRAs to Roth IRAs whenever possible (to qualify for this, by the way, your income cannot exceed $100,000).  We find the case for the Roth far less compelling, except for those who would otherwise be making a non-deductible IRA contribution in the current year.

The only way to compare the Roth with the traditional IRA is to take the costs and benefits of each and reduce them all to present value.  The idea of a "present value" is part of a larger concept called "the time value of money." The time value of money refers to the fact that a dollar received today is worth more than one received a year from now, because the dollar received today can be invested to earn a return during the intervening time.  Likewise, an expense incurred a year from now costs you less than the same dollar expense incurred today, again because the funds used to make the later payment can be invested for a return in the meanwhile. The choice between a traditional IRA and a Roth IRA boils down this:

• Pay more in taxes now and less later, or
• Pay less in taxes now but more later.

By reducing everything to present value, the total after-tax dollars received under each alternative can be compared directly.  Two examples are shown at the right side of this page.  Under the first, monthly installments are made into a new IRA, under the second, an existing IRA is converted to a Roth.

Although a 7% discount rate/rate of return was used, the same result would be found using a higher or lower rate.

The bottom line is this: while it is true that you will draw more after-tax income from a Roth IRA during the course of retirement, the extra amount is no greater than the extra taxes you must pay in order to establish the Roth in the first place.

Even if the Roth IRA showed a modest advantage under one or both of these scenarios, it would be wise to weigh the gain against the uncertainty of future benefits.  A tax-deduction that is currently allowed is a sure thing, while a tax-exemption promised for some future period, possibly decades away, is a far less certain matter.

It is important to remember that a Roth IRA will always make sense if the alternative is a non-deductible traditional IRA. Unfortunately, if your adjusted gross income exceeds $160,000 the Roth is not available and you are limited to making non-deductible contributions into the traditional IRA.

The other reasons for considering a Roth IRA are the ability to defer making withdrawals after age 70 1/2 and the tax-free transfer of the IRA balance at death, features that will be of greater or lesser importance depending on individual circumstances.

Assumptions:

• $2,000 annual contribution for 20 years
• IRA then distributed over the next 20 years
• 7% rate of return (discount rate)
• 36% marginal tax rate

• $100,000 current IRA value
• Held for 20 years after conversion
• IRA then distributed over the next 20 years
• 7% rate of return (discount rate)
• 36% marginal tax rate