will the government raid Roth IRAs?

Why does everyone love Roth IRAs so much? Is it the romantic ideal of a tax-free withdrawal in your old age?  Is it a vision of tax-free growth stretching off into the future?

Creative Commons Licensephoto credit: The G-tastic 7

Let me paint a darker picture. Social Security has always been a defined benefit (for the most part).  You put X amount in, you get Y amount out.  It’s more complicated than that, but there’s never been a requirement attached to that.  Nobody audits your investments or sees if you “deserve” more or less.

Yet at the same time, we know that entitlements are rapidly approaching a critical stage. As a political football, the approaching “disaster” has been used by the various political parties to trumpet their own “solutions,” such as means testing (reducing the benefits to wealthier individuals) and privatization (allowing people to “opt out” of some or all of the Social Security program).

But what I wonder is whether, when all of that fails and the bills from all of our other social spending, war spending, foolish tax policies and declining dollar value comes home to roost, won’t someone see taxing all the “rich” people with Roth IRAs as a potential political solution? I think a perception still exists that Roth IRAs or 401(k)s are for “rich” people with “extra” savings.  What politician wouldn’t think to tax Roth withdrawals “just a bit” to preserve Social Security?  Wouldn’t a 5% tax on Roth IRAs be easier to sell than a 5% reduction in Social Security benefits?

I do not advocate giving up on Roth accounts at all. My wife and I both have one.  But just keep in mind that an IRA or 401(k) which allows you the opportunity to avoid taxes today has some value, too.  The Roth accounts will be tempting targets for politicians when the entitlement system finally starts collapsing under its own weight as the Baby Boomers retire.

14 comments

  • I think the response will be a bit more insidious. We already “means test” Social Security, in that if your income in retirement is above a certain level, you have to pay taxes on half of your Social Security income. I can very easily envision a day where we means test whether or not we receive Social Security at all, since of course the “wealthy” have no need for it.

    To be clear, by far the primary contributor to our upcoming budget conundrum is growth in entitlement spending overall, rather than other parts of the budget.

    I have a friend who is approximately my age and has approximately the same income as me. I save around 25 percent of my income, where he spends every penny and has significant revolving debt. When we retire, I will be considered rich, while he will be considered needy, and he will be entitled to more Social Security and other government assistance. When I point this out to him, he readily agrees and says I am foolish for saving. He may be right.

  • Thanks for the scary thought of the day!

    But do you think politicians could get away with it? Wouldn’t the rich object to those kinds of taxes? I’m making an assumption that the “rich” hold the ear of a politician more than the little guy.

  • I had the same thought as FFB – politicians can raid SS because the rich don’t care. They’ll be a bit more protective of their ROTH IRAs and 401Ks.

    @ Curmudgeon – a life on government assistance is not one I would look forward to!

  • The “rich” who do “hold the ear of a politician” are not concerned about their IRA’s and 401(k), they are so wealthy, they don’t bother saving it in IRAs. The usual “rich” who will be paying in the end are the middle class folks.

  • As someone who was never going to take US citizenship, I always thought they’d pull a number on the (many many) non-citizens with regard to taxes, roths etc. But your prediction makes sense too.

  • Hmm, a scary thought. All this saving does seem silly sometimes…saving for your future, sometimes at the expense of your current situation…so curmudgen’s friend might be doing things “right” if he passes on before he retires…

    Okay, i think that made me sound creepy, but yes, I agree that the on top taxing of the retirement accounts will probably affect the middle class the most.

  • Steve,

    Your concern may have a reasonable probability.

    If a FairTax (i.e. consumption tax) ever passes, Roth IRAs will be taxed, at the time of spending. In addition, savings prior to enactment of a FairTax will also be double taxed since they will be taxed again at the time of spending 🙁

  • Well, we don’t know where the taxmans hits will come in the future. who knows if they’ll grab the roth ira. We can only plan as best we can and hope for the best….I have a traditional IRA .

  • The unusual tax laws that are in existance around 2009-2011 may be more of an indicator. While Roth IRA’s, 401k’s and 403(b)’s may be taxed in the future, I am betting that they will not & will represent a loophole to be closed, instead of uniformly redacted. Once the elder wave hits in force and SS becomes less solvent, there will need to be incentives (rather than disincentives) to save (along with probable means testing). Punitive taxing of retirement accounts (which already exists, particularly in the setting of inheritance) will do nothing to help the government’s plight.

    There is a planned window in 2010 for IRA conversions where the previous income limit for Roth type accounts is to be removed. In other words, previously if you made over a certain amount, you could not convert to a roth in that calendar year. In 2010, that requirement will be lifted (google: 2010 ira to roth conversion ) with a special benefit of paying the tax over two years. Seems to be a one time deal, but who knows? Surprised that nobody has mentioned the Nondeductible IRA to Roth strategy.

    Anecdotally, multiple mid high net worth types (2M-10M net worth range) have been planning for this not only for themselves but their children with stretch roth accounts according to one of my contacts at a mid size bank’s trust division.

    It will take a while to reverse the trends in law and politics that have occurred over the last 30 years. While nobody can predict the future, you can pay attention to current trends and provide accordingly.

    The above is not mean to be construed as financial advice and I do not hold myself out as a financial advisor. This post is for entertainment value only. There can be a risk of loss with any financial endeavors, and you are hereby directed to consult your financial, legal, and tax advisors to obtain advice specific to your own situation.

  • Congress operates under pay-as-you go procedures, so that typically revenues/spending are accounted for their effects over 5 years – 10 years. So if someone wants to increase spending on, say, food stamps, he has to offset it it with revenue increases or other spending cuts. For Congress, Roth provisions are revenue INCREASES. Why? Because you pay all future taxes in the five years window. That is why the Roth provision was added, and why it was added for 401ks. It can still be added for 457 plans, to the Federal TSP. And when it is, it will be scored as saving money.

    Many of these same budget rules work to Roth owner’s advantage on the back end, also. See http://www.irs.gov/pub/irs-soi/08sprbul.pdf and look on page 90-103. In 2004, over 6 million people contributed to Roth IRAs. That is alot of voters to anger. They contributed about $15 billion. Assuming an average tax rate of 25%, that is $3.75 billion of revenue gain for the govt in that one year. Taxing IRAs would lose the $3.75 bln in revenue (increasing each year in the future). Plus, $2.8 bln in IRA assets were converted to Roth plans, again contributing about $700m to the govt.

    So the govt would lose about $4.45 bln annually if it eliminated the Roth provision or began taxing Roth accounts. The gain to the govt would be taxes on distributions. From rough back of the envelope calculations, Roth assets would have to be 3.5x larger than they are now for the govt to gain more in taxes on distributions than it would on contributions. Of course, the amounts in Roth IRA plans will increase, but as they do, a part of the increase will be in contributions, which will increase the cost to Congress of withdrawing the Roth IRA provision.

    Note that this does not address the political calculation of angering the 6 million people who made contributions that year, or the 13 million Roth IRA account holders.

    In any case, it should be quite some time before taxing Roth IRAs or withdrawing their special tax status would be economically attractive to the Congress, much less politically attractive.

  • My husband and I have had Roth IRAs since the age of 16, but we’ve decided to hedge our bets and open a traditional IRA as well.

    Our thinking is that if we have a mix of Roth, traditional and non-retirement funds to pull from, we should have more control over our tax situation regardless of how things pan out in 20-40 years. The way things stand now, we can theoretically choose to pay no tax (Roth), capital gains tax (investments), or just plain income tax (traditional), depending on our other income, the state of the tax system and our taxes for that year.

    Of course, this all goes out the window if the U.S. passes a consumption tax!

  • I’m a little late on this one, but….

    I believe at some point Roths will be taxed. But of course they can’t tax the full amount of the withrawal because contributions have already been taxed.

    My guess is they will enact some form of a capital gains tax only on the “gains”. Hopefully it will be less than the full cap gains rate.

    I would also predict sometime in the next decade Roths will disappear entirely. Given that they were enacted by politicians to gain more tax revenue NOW at the expense of the future, when the future comes and they realize the full ramifications they will end it.

    But I still like the idea of a Roth as a hedge against the uncertainty of future taxes. Combine that with my young age and it’ hard to pass up.

  • roth_ira_work

    Yep! I was agreed, I'll keep in touch to your blog.

  • Roth_IRA_Work

    I'll post the same information to my blog, thanks for ideas and great article.