This is Part 2 of an article on the math behind choosing between regular IRAs and Roth IRAs. Part 1 appeared in the September issue of Financial Advisor.

In this article we will explore further the differences between Roth IRAs and regular IRAs, looking at the pros and cons of each. As we discussed in Part 1 of this article, the vehicle you choose will ultimately depend on how accurately you envision your future—your financial life and what your marginal income tax rate is likely to be.

Taxpayers can contribute cash each year into either type of IRA, up to a specified cap. In 2022, the annual contribution limits were $6,000 for persons under 50 and $7,000 for persons 50 or older; in 2023, these limits are $6,500 and $7,500 respectively. Contributions to a regular IRA can also be made before or after taxes, depending on whether the taxpayer has already made maximum tax-deferred contributions into a 401(k) or another retirement fund. The Roth IRA, however, is also subject to an income cap that prevents higher earners from using it. That cap is based on modified adjusted gross income, or MAGI; the ability to contribute is phased out quickly over a relatively narrow income range, and the range is adjusted annually based on inflation. In 2023, the Roth IRA MAGI phase-out range income limit for singles is $138,000 to $153,000 while for married couples filing jointly it is now $218,000 to $228,000.

Funding Roths Through Conversions
One way higher income earners can work around the limits is to convert a regular IRA or 401(k) account into a Roth IRA.

For example, if you leave a job where you have a traditional 401(k) account, one of your choices is to roll some or all of those investment assets into a Roth IRA. This may be especially tempting if you think your projected future earnings at your new job will put you above the income limitations. By converting a regular IRA or 401(k) into a Roth IRA, you will trigger current taxes, but after that the income and growth inside the Roth IRA come out tax free. If you have pretax contributions in your 401(k) and do not want to recognize the income right away (perhaps because you think you can pull it out later at a lower tax bracket) you can avoid current taxation by rolling the assets into a regular IRA. If your 401(k) account has both pretax and after-tax contributions, you can minimize or avoid current taxation by allocating the after-tax contributions to a Roth IRA and the pretax contributions to a regular IRA.

For example, let’s assume you have $1 million in a traditional 401(k) account and the plan allows you to convert this investment into a Roth 401(k). The conversion is a fully taxable event, and you will have $1 million of income added to your tax return in the conversion year. Thereafter, all investment income or gain in the Roth 401(k) is tax free, assuming you meet the applicable requirements (you must hold it until you’re 59½ years old and you must hold new Roth investments for at least five years). Let’s also assume that you’re in the highest income tax bracket, paying a constant effective tax rate of 40%.

Now say that the investment doubles in 10 years. If the $1 million is left in the traditional 401(k) and doubles to $2 million and then is distributed at year 10, the 40% tax costs $800,000 and leaves an after-tax amount of $1.2 million. The Roth 401(k), meanwhile, could distribute $400,000 to pay the taxes on the conversion date, and the remaining $600,000 would double to $1.2 million over 10 years. So if the tax rates remain the same, the remarkable epiphany is that the two strategies produce an identical result.

One further insight is that the taxpayer can choose to pay the $400,000 in conversion taxes from assets outside the plan, and therefore can put the full $1 million into the Roth 401(k). That has the mathematical effect of increasing the balance in the Roth 401(k) account from $600,000 to $1 million. That would likely make sense even if tax rates are projected to remain the same.

Roth Withdrawals And The Five-Year Rule
You can withdraw the after-tax contributions made to your Roth IRA at any time and at any age without penalty. This makes sense because the contributions are your after-tax money. At age 59½, you can also withdraw your investment earnings without penalty, though you must first observe the “five-year rule,” which requires that “new” Roth investments be held for at least five years before the income from the investment can be distributed tax free. This five-year rule applies even if the contributions are made after you reach age 59½. The purpose of this rule is to make sure taxpayers cannot play short-term timing games with Roth investment income.

The five years is computed in a typically convoluted manner. The counting starts on January 1 of the year in which you make your first contribution to the Roth. Note that you have until April 15 of the following tax year to make a contribution and so the actual holding period could be substantially less than five full calendar years.

For example, let’s say you contributed to the Roth IRA on April 15, 2019, but designated it as a contribution for the 2018 tax year. The five-year period is over on January 1, 2023, and thereafter you can withdraw all Roth IRA earnings without tax (so long as you are at least 59½ on the withdrawal date).

The Five-Year Rule And Rollovers
When existing funds are rolled over from a Roth 401(k) to an existing Roth IRA, the transferred funds inherit the same five-year period as the Roth IRA. Thus, the five-year period for a Roth IRA applies to all funds held in that account, including any funds rolled over from a Roth 401(k).

If there is no existing Roth IRA and a new one is established, the five-year period begins with the year that the new Roth IRA is opened, regardless of how long the funds may have been held in the Roth 401(k).

If funds are rolled over from a traditional 401(k) to a Roth IRA and a taxable conversion election is made, the five-year period begins for the year when those funds are contributed to the Roth IRA. If you withdraw earnings before the five-year period is done you could trigger both income taxes and, if you do it before age 59½, a 10% penalty.

So What To Do?
With all the insights and technical information provided in this two-part article, we can now come back and offer a more informed answer to the question: “What the heck should I invest in? A regular IRA or a Roth IRA?”

The right answer is probably a combination of both but skewed (perhaps heavily) one way or the other, depending on your specific situation.

If you think retirement is going to put you into a lower tax bracket (after taking into account Social Security and all your required minimum distributions) then a regular IRA makes sense and maximizes your after-tax return.

On the other hand, if you think your tax bracket in retirement is going to stay at the highest levels (congratulations by the way!) and that the incremental income from your required minimum distributions will thus get clobbered by higher rates, then a Roth IRA makes complete sense—especially if you want to leave the assets to your kids instead of to a charity.

If all of this leaves you as confused at the end as you were at the beginning, welcome to the club. Splitting retirement contributions between regular IRAs and Roths—or between traditional 401(k)s and Roth 401(k)s—makes a lot of sense in a complicated and uncertain world.

In short, the world is a mess—and your IRA investment strategies should cheerfully reflect that fact.

Joseph B. Darby III, Esq., is an adjunct professor at the Boston University School of Law and the founding shareholder of Joseph Darby Law PC, a law firm that concentrates on sophisticated tax and estate planning for individuals and businesses.