In 1998, Congress created a new way to encourage people to save for their retirement. The Roth IRA turned retirement planning upside-down by shifting the focus from current to future tax savings. In conjunction with a method allowing many investors to convert their traditional retirement accounts, the new Roth IRA provisions held the promise of increasing current tax revenue as well as offering retirement savers an alternative to the traditional methods of putting money away for the future.
In the first decade of their existence, limitations based on gross income have made Roth IRAs largely unavailable to wealthy taxpayers. However, a recent provision modifying these rules will make it possible for everyone to convert existing traditional retirement accounts to Roth IRAs in 2010. Although this may significantly boost current tax revenue, the future tax revenue the government stands to lose may force it to reconsider such tax benefits in decades to come.
Paradigm shift in retirement planning
The Roth IRA changed the way people thought about the tax implications of retirement savings. Until it arrived, retirement savings had always used the concept of deferred compensation as a model; the primary advantage of using tax-favored retirement accounts like traditional IRAs and employer-sponsored retirement plans was an up-front tax deduction equal to the amount of your contribution. The benefits were obvious: a tax break now, and tax deferral until retirement. The only downside was that you'd pay tax when you withdrew the money after retirement, but for most investors, that seemed a small price to pay for both the initial tax break as well as decades of deferred taxation.
With Roth IRAs, on the other hand, avoiding current taxation isn't part of the incentive to set up a retirement account. As long as you meet several requirements, neither your initial contribution nor any earnings your account generates over the years will ever be subject to income tax. In addition, the Roth IRA rules encourage their use for estate planning. Unlike traditional IRAs, which require minimum withdrawals after you reach age 70-and-a-half, there's no requirement that you ever take money out of your own Roth IRA. Only once your heirs inherit your Roth IRA will they have to begin taking withdrawals, and even then, they can space out their distributions over the course of their respective lifetimes.
In many ways, the Roth IRA has brought the benefits of retirement saving to low-income and middle-class taxpayers. For the most part, the richest taxpayers benefit the most from traditional IRAs and other deferred compensation arrangements; they avoid taxation at the highest tax rates, currently 35%, with the expectation that their tax bracket is unlikely to be any higher than that after their retire. On the other hand, if you only pay tax at a 10% or 15% rate, the value of contributing to a traditional IRA or 401(k) at work is substantially less. The Roth IRA, however, allows these low-bracket taxpayers to pay tax on their contribution at current low rates, thereby avoiding taxation in the future. Since their tax rates are low now, it's unlikely that their taxes would fall any further after retirement, so the value of avoiding future taxation is relatively high.
The cost to government
In a few years, however, the rules for Roth IRAs are scheduled to change in dramatic fashion. Currently, any taxpayer with adjusted gross income of $100,000 or more is not allowed to convert any traditional IRA assets into Roth IRAs. In 2010, current law would eliminate the $100,000 limit, allowing anyone to convert their traditional retirement accounts to Roth IRAs. Many commentators, including personal finance expert Suze Orman, are already looking forward to the opportunity to convert. For one thing, even for taxpayers in the highest tax bracket, current tax levels are fairly attractive. With top brackets in the past surpassing 90%, paying 35% is a bargain, and after considerable reductions in taxes over the past 20 years, it's logical to assume that the next move is more likely to be up than down.
Using its typically short-sighted 10-year time frame for evaluating the budget impact of the new Roth conversion provisions, Congress estimates that eliminating the income limitation for conversions will increase tax revenue by about $6.4 billion. However, these estimates take into account all the current revenue generated by the conversions, while leaving out the negative effect of the vast majority of lost future tax revenues that those conversions will eliminate. According to estimates by the Urban Institute, the long-term cost of expanding Roth conversions will be more than $14 billion over the next 40-45 years.
Some skeptics point out that Congress could always modify the Roth IRA rules to allow taxation of distributions. However, to rely on that as a solution to revenue shortfalls would be an injustice on retirement savers. As beneficial as these provisions are for savers, only by repealing the change in Roth eligibility rules that would allow high-income taxpayers to convert traditional IRAs can Congress take the fiscally responsible course of action.
As a taxpayer, you want to maximize your tax benefits. However, the death knell for many favorable tax provisions has come when taxpayers got too greedy. If limits on Roth conversions disappear in 2010, it may force Congress to take drastic action that could eliminate Roth IRAs entirely. If that happens, it will be a sad day for retirement savers.
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Fool contributor Dan Caplinger has been waiting for a good year to convert some of his IRAs, but he may have to wait until 2010. The Fool's disclosure policy is good for everyone.