When Roth IRAs first became available to Americans in 1997, they marked a brand-new investing opportunity for retirement savers. Yet Roth IRAs have never become as popular as many believed they would, and the reason is simple: Many fear that they're too good to be true. Specifically, the concern among would-be retirement savers is that future lawmakers will retroactively take away the amazing tax benefit that makes Roth IRAs so attractive as a retirement-savings vehicle.
The huge tax break Roth IRAs offer
Prior to the introduction of the Roth IRA, the primary attraction of retirement accounts was the up-front tax deduction that you got for making contributions. With both traditional IRAs and employer-sponsored retirement plans like 401(k)s, the money you put into your retirement account reduces your taxable income, cutting your current tax bill and letting you take advantage of tax deferral within the retirement account throughout your career.
The trade-off, though, is that when you take money out of a traditional IRA or 401(k), you have to pay tax on that amount. Essentially, what the IRS gives you up front, it takes away in retirement. For many retirees, this arrangement works well, as a tax deduction during the high-income years of your career will outweigh the taxes you pay later if you end up retiring in a lower tax bracket.
Roth IRAs, however, reverse savers' incentives. Roths offer no tax deduction when you make contributions. But in retirement, withdrawals are tax-free, even for the income and capital gains that investments within the Roth account generated. That's a huge pool of tax-free savings that can make it far easier for people to plan what their retirement will look like.
Yet as powerful as that benefit is, Roth IRAs have never really caught on: Just 8% of total IRA assets are in Roth IRAs, according to figures from the Employee Benefits Research Institute's IRA Database. Roth IRAs make up less than a quarter of all IRA accounts, and although Roths have seen balances grow at a faster pace recently, they still tend to have substantially less money on average than corresponding traditional IRA accounts.
A honeypot for Congress?
The fear that many Americans have about Roth IRAs is that lawmakers will see the pool of Roth IRA assets as a potential source of future tax revenue. With the federal budget still running substantial deficits, the temptation to view tax-free Roths as an opportunity to impose new taxes won't go away anytime soon.
In addition, what some people see as abuse of the tax-free nature of Roth IRAs has led to past scrutiny. A few years ago, Yelp board chairman Max Levchin gained notoriety for using his Roth IRA to hold a portion of his stake in the social-network review service, earning a nine-figure tax-free windfall when Yelp went public. Other stories of investors in the hedge fund and private-equity world using financial engineering to boost their Roth IRA balances also drew attention from critics of the tax-free accounts. Future lawmakers could use those extraordinary stories as a justification for taxing Roth IRAs more broadly.
Still, there are reasons not to fear Roth IRA taxation. So far, even proposed changes to Roth IRAs have centered on less important aspects of the accounts. For instance, the President's budget proposal earlier this year included a provision to force Roth IRA account holders to take required minimum distributions starting at age 70-1/2, as traditional IRA investors already have to do. It also provided for the end of so-called "stretch" treatment for all inherited IRAs, requiring heirs to withdraw all balances within five years after the death of the primary account-holder.
More importantly, at this point, lawmakers have an incentive to encourage Roth IRA use. Every dollar of traditional IRA money that gets converted to a Roth IRA brings in tax revenue now, and any hint of future curbs on Roth benefits would hurt conversion volume. Down the road, once enough money is locked in Roth IRAs, the political will against imposing taxes on a huge swath of the American population should be stronger. That increases the likelihood that any future changes to Roth IRAs would be prospective, rather than retroactive, grandfathering existing account-holders to retain their benefits.
There's no telling for sure what future lawmakers might do to Roth IRAs. But given the advantages of using Roth IRAs for many Americans, you should still consider them as part of your retirement planning. For those in low tax brackets right now, Roth IRAs could be your best available savings option in order to retire rich -- and you shouldn't let an uncertain future scare you out of using them.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool recommends Yelp. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.