Reap the Rewards of a Roth IRA

You can contribute up to $5,500 to a Roth ($6,500 if you're 50 or older) in 2015, as long as you're not a high earner (see below). You can invest in a Roth even if your employer offers a 401(k) plan. Ideally, you should fund both to the max; the 401(k) contribution limit is $18,000 for 2015, or $24,000 if you're 50 or older. Or at least invest enough in your 401(k) plan to get any company match and then contribute to a Roth.

When retirement is decades away and you don't have much money to spare, it may seem silly to sock money in a Roth— especially when contributions to a traditional IRA, 401(k) or other tax-deferred retirement plan are rewarded with an immediate tax break. But when you're in a low tax bracket, the up-front savings from a deductible IRA may be minimal. Plus, a Roth's long-term payoff is huge: In exchange for giving up the immediate deduction, you'll be rewarded with years of tax-free earnings growth. And as long as you wait until you're 59½ to take withdrawals, none of the money will be taxed, no matter how high your tax bracket when you start spending the money.

When you're in your peak earning years, the break you receive for contributing to a tax-deferred retirement plan becomes more valuable. In addition, the benefits of a Roth are less compelling if you think your tax bracket in retirement will be lower than it is now. Still, diverting at least a portion of your savings to a Roth could pay off big when you retire --- particularly if you didn't fund one when you were younger.

Income limits on Roth contributions affect high earners, but they're not insurmountable. In 2015, single taxpayers with modified adjusted gross income of $131,000 or more are ineligible to contribute to a Roth; those with MAGI of between $116,000 and $131,000 can contribute a reduced amount. For married couples who file jointly, the income limits phase out between $183,000 and $193,000; those with MAGI of $193,000 or more are ineligible to contribute to a Roth.

One way around the problem is to convert a traditional IRA to a Roth. There are no income restrictions on Roth conversions; anyone can do it. However, you must pay taxes on all pretax contributions and earnings up to the time of the conversion. You can minimize the taxes by converting gradually over several years. Because taxes are based on the value of your IRA when you convert, you can also take advantage of market downturns to lower your tax bill.

Some high-income savers have embraced a strategy known as a "backdoor" Roth IRA. With this maneuver, you invest after-tax dollars in a nondeductible IRA, then convert it to a Roth. As long as you convert before any earnings accumulate, the transaction is tax-free. There's one important caveat, though: If you already own a deductible IRA (a rollover from a former employer's 401(k), for example), your tax bill will be based on the percentage of taxable and tax-free assets in all of your IRAs, even if you convert only one of them. For example, if you have $5,000 in a nondeductible IRA and $95,000 in a deductible IRA and convert $50,000 to a Roth, then 5%, or $250, would be tax-free.

An easier approach is to direct some of your retirement-plan contributions to a Roth 401(k), if that option is available to you. Nearly 60% of large employers offer the Roth version, according to Aon Hewitt, a human resources consulting firm. There are no income limits on Roth 401(k) contributions. Deposits are after-tax and earnings on those amounts will be tax-free; any matching contributions from your employer go into a regular pretax account, though, and earnings in that account will be taxed when withdrawn. (Don't worry. Your plan has to keep track of these things.) As with Roth IRAs, once you're 59½ and have owned a Roth 401(k) for at least five years, withdrawals are tax- and penalty-free.

About one-third of employers that offer this option allow plan members to convert some or all of a regular 401(k) to a Roth 401(k). You'll pay taxes on the amount you convert, but after that your earnings will be tax-free. There is a big difference between converting an IRA and converting a 401(k), however. Unlike an IRA conversion to a Roth, which can be reversed within a certain period of time, there's no do-over with a Roth 401(k) conversion.

One downside to Roth 401(k) plans is that you must take required minimum distributions from the account when you turn 70½. This problem is easily avoided, though, by rolling the account into a Roth IRA when you retire. Roth IRAs aren't subject to RMDs.

Reaping the benefits in retirement

A Roth in your arsenal gives you the flexibility to avoid bracket-busting withdrawals in retirement, says Ken Perine, a certified financial planner with Meritage Wealth Advisory, in Livermore, Calif. Withdrawals from traditional IRAs and 401(k) plans are taxed as ordinary income, and the money you take out could push you into a higher bracket (the brackets currently extend from 10% to 39.6%). What's more, the additional income could subject you to a host of unpleasant consequences, ranging from higher Medicare premiums to a surtax on your investment income.

If you've made it to retirement without investing in a Roth, you can still add one to your retirement portfolio, and you probably should. You need earned income to contribute to a Roth, so if you're no longer working, this door is closed. But you don't need earned income to convert a deductible IRA to a Roth. And depending on your circumstances, you may be able to convert without paying a big tax bill.

For example, suppose it's your first year of retirement and you've socked away enough in a savings account to cover your expenses for the year. Because you aren't working full-time and have reduced income, you can convert a significant amount of money from your IRA at a low tax rate, says John Scherer, a certified financial planner in Middleton, Wis. In 2015, a married couple can have up to $74,900 in taxable income and remain in the 15% tax bracket. Even if your conversion moves you into the 25% bracket, you'll only pay that rate on the amount that exceeds the threshold. For example, if your conversion results in taxable income of $77,900, you'll pay 25% on only $3,000.

You'll always be able to withdraw the amount you converted without paying taxes or penalties. And after five years, you can withdraw earnings tax- and penalty-free, too (as long as you're at least 59½). (Converting to a Roth also shrinks the amount remaining in your deductible IRA, which you'll appreciate once you turn 70½ and start taking annual required minimum distributions from the account.)

The longer you leave the Roth untouched, the more you'll benefit from tax-free earnings growth. For that reason, financial advisers often recommend tapping taxable accounts first, followed by your tax-deferred retirement accounts, and finally, your Roth IRA. However, if you need a large amount of money for an emergency (and don't have enough in your taxable account to cover it), you can take it out of your Roth without triggering a big tax bill.

Similarly, smaller withdrawals from your Roth will allow you to maintain your retirement lifestyle without some of the unpleasant tax consequences ignited by taxable withdrawals from your deductible IRAs or 401(k) plans. For example, taxes on Social Security benefits are based on what's known as your provisional income— your adjusted gross income (which includes withdrawals from your 401(k) or a traditional IRA), plus any tax-free interest, plus 50% of your benefits. If you substitute tax-free withdrawals from your Roth to cover some of your needs, you may be able to keep your AGI below the thresholds that trigger higher taxes.

Better yet, tax-free withdrawals may help you postpone taking Social Security benefits— and each year you delay claiming benefits between age 62 and 70 boosts your payout by as much as 8% a year. Using tax-free withdrawals to manage your taxable income could also lower Uncle Sam's take of your taxable accounts. Long-term capital gains are tax-free for taxpayers in the 10% or 15% tax brackets.

Another advantage of the Roth is that if you don't need the money, you don't have to start taking it out of the tax shelter at age 70½, as you do from regular IRAs and 401(k)s. Significant mandatory distributions from such accounts can push you into a higher tax bracket.

The benefits of a Roth continue even when you're not around to enjoy them. Money in an inherited Roth account can be withdrawn by heirs tax-free over their lifetimes. With a traditional IRA, withdrawals are taxed at your heirs' top tax brackets.

Tap it if you need it

Money you stash in a Roth isn't completely locked up. You can withdraw your contributions at any time, tax- and penalty-free. We don't recommend it (remember, the money is for retirement), but in an emergency, your Roth is there for you.

Once you have retrieved all of your contributions and dip into earnings, you'll usually pay taxes on those earnings if you withdraw them before age 59½, along with a 10% penalty. But there are exceptions. After you've owned the Roth for at least five years, you can withdraw up to $10,000 in earnings toward the purchase of your first home, tax- and penalty-free. If you take withdrawals of earnings to pay for a child's college costs, you'll pay taxes but you won't have to pony up the 10% early-withdrawal penalty.

Roths are for kids, too

Note to parents: Helping your children fund a Rothis a great way to start them on the road to a secure retirement. As long as your children have earned income, they're allowed to contribute to a Roth, even if they don't use their own money. You can contribute up to the regular annual limits or 100% of what they earned for the year, whichever is less. Even teenagers are eligible for a Roth as long as they have earnings from a part-time or summer job.

If you own your own business and pay your child to do administrative work, cleaning or other tasks, those earnings also count toward Roth eligibility, says Steve Burkett, a certified financial planner in Bothell, Wash. A Roth "is a great way to start educating children on long-term investing and gives them an invaluable source of tax-free income during their retirement," he says. Look for a firm with low fees and low investment minimums. TD Ameritrade, for example, has no minimums or annual fees for its IRAs, including custodial accounts held by parents or grandparents for children.

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Sandra Block is a senior associate editor for Kiplinger's Personal Finance. .