The Future of the Roth IRA
Will the Roth turn out to be a bad idea with future changes in the tax law?
Some people advise caution in moving to the Roth IRA because of the possibility of future changes in the tax law. What if Congress decides to tax Roth IRA earnings? What if we move to a flat tax, or a national sales tax?
Changing Times
Some people worry about this possibility: years from now, with the baby boom generation retiring in droves and huge amounts of investments tied up in Roth IRAs where earnings will never be taxed, Congress will be desperate to raise revenues. Some form of tax will be imposed on Roth IRAs out of sheer necessity. After all, the same thing happened to social security benefits.
There's no guarantee that something like this won't happen. I think it's very unlikely, though. The policy decision to tax social security benefits was on very different grounds. Congress never enticed people to enter the social security system with the promise that benefits would be tax free. There wasn't a bait and switch. The initial decision was to create a safety net and not tax the benefits; later Congress decided that people at certain income levels should pay tax on part of the earnings. That's very different from reneging on a promise to leave earnings free of tax.
From time to time, Congress has changed the law to cut back on benefits of various types of retirement plans. These changes have generally been accompanied by generous transition rules to protect those who relied on prior law. Similar treatment seems likely if Congress decides at some point to cut back or shut down the Roth IRA.
Flat Tax, Sales Tax
Is there a flat tax or a sales tax in our future? If so, will it reduce rates so dramatically that people will wish they never heard of the Roth IRA?
Politicians have been talking for years about fundamental tax reform. For a while it was fashionable to promise to make taxes so simple you can file on a postcard. A few years back, House Majority leader Dick Armey vowed to rip the income tax out by its roots. How long can the current tax law withstand this assault?
A long time, I'm afraid. There are a couple of problems with getting rid of the income tax. One is that no one has come up with a viable alternative. Another is that the income tax is woven so completely into our entire economy that it would take many years to switch to a different system, assuming we were willing to do so.
All of the alternatives to the present income tax that have been proposed have different flaws, but most have one major flaw in common: they shift the tax burden from the wealthy to those who are less wealthy in a major way. Cynics tend to believe that wealthy Americans are able to avoid paying income tax, as Leona Helmsley was quoted as saying: "Only the little people pay taxes." The reality is quite different. There's no shortage of shenanigans among wealthy taxpayers, of course, but when all is said and done, the highest income Americans pay a whopping share of the income tax. The various flat tax and sales tax proposals would change that dramatically. When people take a close look at the flat tax, it starts to lose its shine.
One of the big complaints about the income tax is its complexity. But that's also one of the big problems with getting rid of it. The income tax is woven into our economy in innumerable ways. People always mention the millions of Americans who count on being able to deduct their home mortgage interest, and the charities that rely on the contribution deduction to keep donors interested. That's just the tip of the iceberg. There are literally trillions of dollars invested in various types of arrangements designed to provide income tax benefits of one kind or another. Pension plans, rental property, plant and machinery, government bonds — the list goes on and on, and reaches every facet of government and industry.
Change is possible, of course, but a sweeping change of the type many politicians like to suggest would require many years of study just to plan for it, and at least a decade of transition. Notably, for all the talk in Washington about repealing the income tax, Congress hasn't taken even the first step toward developing a plausible alternative.
And there's another possibility the cynics generally fail to mention. Congress could make changes that will make the Roth IRA more attractive. We may see tax rates in the future that are higher than they are now. That would mean a windfall to those who converted before the higher rates took effect. Read my lips: it could happen.
Conclusion
This page is different from most on this web site, in that it's based more on my opinions than on my knowledge. I've tried to draw on that knowledge to support the opinions, but they remain just that: opinions. "Your mileage may vary."
I offer these thoughts out of a sincere belief that a small but significant minority of people who would benefit from converting their IRAs may fail to do so out of unfounded beliefs about the likely future course of the income tax system. My hope is that reflection on the points made above will lead some of those people to make a choice that will ultimately provide them with handsome financial rewards.
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