The Roth IRA has become immensely popular in the nearly 20 years since it was first created - driven no doubt by its favorable tax-free treatment for all growth spent in retirement. From Roth IRA contributions, to Roth conversions, or Roth 401(k) and other employer retirement plans, there are more and more ways to get money into a Roth.
In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we look at the issue of whether retirees may be banking on too much of a good deal, though, and whether Congress might someday repeal the tax-free Roth treatment and renege on the Roth promise. Should retirees hedge their bets against a future tax law change?
Fortunately, the reality is that while repealing tax-free Roth treatment is legally possible for Congress to do, it is politically unlikely. Not just because it would be immensely unpopular with active senior voters, but also because eliminating Roth treatment actually scores very poorly in Federal revenue projections, due to the 10-year budgeting process that is typically used to analyze major tax law changes.
Notwithstanding this, however, the odds are still good that some "crackdowns" and loophole closers do come for Roth accounts soon. Potential changes include introducing Required Minimum Distribution (RMD) obligations to Roth IRAs for those over age 70 1/2, the elimination of the stretch Roth IRA for young beneficiaries, a cap on maximum IRA account sizes beyond which no new contributions are allowed, and the elimination of the so-called backdoor Roth IRA (which arguably is already risky if done too aggressively).
Of course, none of this entirely eliminates the value of contributing to a Roth IRA as long as your tax rates are low, but it makes the timing of when it's best to contribute to a Roth IRA (versus making a traditional IRA or 401(k) contribution and doing a Roth conversion later), more important than ever!
(Michael’s Note: The video below was recorded using Periscope, and announced via Twitter. If you want to participate in the next #OfficeHours live, please download the Periscope app on your mobile device, and follow @MichaelKitces on Twitter, so you get the announcement when the broadcast is starting, at/around 1PM EST every Tuesday! You can also submit your question in advance through our Contact page!)
#OfficeHours with @MichaelKitces Video Transcript
Welcome, everyone! Welcome to Office Hours with Michael Kitces.
Will Congress Someday Renege On The Tax-Free Roth IRA Promise?
The topic today is Roth retirement accounts, and specifically this idea of what's the risk that Congress someday could break the "Roth promise" as I call it. This wonderful tax-free treatment. What's the risk that it could change someday?
This question came from an advisor who wrote to me. I'm reading Aaron's question. Aaron says, "So an advisor in my office warns of ignoring the political risks when recommending clients to max out a Roth 401(k) or a Roth IRA over traditional." In Aaron's words, "I argue that they should do the Roth anyway since subconsciously they may be saving a little more and they get the better tax benefits. Do you think it's realistically a possibility that future acts of Congress could strip out the tax-free withdrawal benefits from high-balance Roths that have been funded with after-tax dollars. I.e. could Congress someday renege on the Roth promise?"
This is a challenging question that we hear a lot. Gary commented at the top of the show he hears it as well. We hear it occasionally from clients in practice, too. People are raising this question. What's the possibility that Congress could sometime in the future just undo, or renege, on the Roth promise and get rid of the beneficial Roth IRA rules?
Can Congress Renege on the tax-free Roth IRA?
Let's start with the political reality. First, can Congress do it? I think the answer here is pretty unequivocally: Yes. Congress has it within their rights to change the tax treatment for Roth retirement accounts at some point down the road, draw a line in the sand, and say, "Oh, well, we used to allow qualified withdrawals from Roths to be tax free, but we changed our minds, we're not going to allow that anymore." So the question of could it happen? Yes, it's legitimately possible.
Now, will it happen? As Aaron put it, is it realistically possible that this is going to happen? And really I think the answer is realistically no.
There are a couple of reasons for this. The first is the reality of political expediency, and how laws get made in Washington, and how they get evaluated. The way that a new major tax rule typically gets measured, or what they call "scored" in Washington, for its potential revenue and tax impact... the Congressional Budget Office typically looks at this over 10-year time windows. Joint Committee on Taxation does their own work, also looking at 10-year time windows.
How Do Proposed Roth IRA Changes Score In Congress?
So the first challenge of "would Congress ever eliminate the Roth promise" is ironically, notwithstanding just the political blowback that would come from it, is that repealing the Roth promise doesn't actually look very good on a 10-year fiscal basis, either. It doesn't score well on a 10-year projection. Because not that many people are going to take money out of a Roth IRA or Roth 401(k) over the next 10 years anyway, especially if you make them taxable. And now people will want to keep the money in the account longer. So again, it doesn't score well, to use the terminology that Congress looks at.
This is actually the same reason why you're seeing all these rules changes over the past 10 years eliminating or relaxing Roth conversions, and making it easier to do Roth conversions. Because if you take an IRA that normally wasn't going to get withdrawn until the distant future, so the revenue value was zero, and you relax the rules for Roth conversion so more people do Roth conversions now, then you accelerate the tax consequences that would've been 20 or 30 years out into the 10-year window. It looks like Congress "created" revenue by permitting this conversion that draws money forward, and it actually has a revenue-positive impact.
Certainly for any of us as advisors, we know the reality of this is people are going to take it out someday anyway. So you didn't really create revenue. You just shifted it forward from the distant future to the current future.
But when Congress does this and looks in 10-year windows, it looks like they created revenue. Ironically this means that if Congress wanted to come in now and eliminate Roth conversions, it would have a negative revenue impact, which means if the legislation was going to be revenue-neutral we'd actually have to come up with a new tax to pay for eliminating Roth conversions, which is not realistically going to happen. If Congress is going to come up with new taxes to pay for stuff, the primary thing that they want to pay for is not eliminating Roth conversions! It's going to be for other programs, other stuff, from either side of the aisle.
So you get this challenge that eliminating Roth rules at best doesn't really bring much revenue into the time 10-year window. And at worst, by cracking down on conversions or making it unappealing to do conversions, it actually looks like a revenue loss for Congress, which means they would have to create new taxes to offset it to make it politically feasible to get it done, since most legislation in Congress must be revenue-neutral to pass right now. That virtually entirely kills the realistic likelihood that we would change the Roth treatment any time soon.
Politicians Don't Want To Lose Their Senior Voters!
Of course, all of this is before you get into the voting realities of trying to change Roth rules. This is a retiree account. Retirees vote. Seniors vote a lot. That's actually one of the reasons why changing almost any thing related to seniors are the third rail of politics. We don't touch Social Security. We don't touch Medicare because seniors vote and organizations that represent them like AARP are ludicrously powerful in their lobbying capability [and block virtually all changes that would be adverse to seniors].
So from a practical perspective, I view the odds of this as virtually nil simply because it would be political suicide for a politician to try to go after Roth accounts. And just from a pure self-interest perspective, politicians like getting re-elected, and they don't want to go down in a glorious ball of flames by trying to kill Roth accounts. If they're going to go down, they're going to go down for something more principled than trying to kill a Roth account!
Which means repealing tax-free Roth treatment doesn't look good from any of the actual realities of the politicking of how this gets done. It's not good from a voting re-election perspective. Even in terms of sort of the fiscal implications, it actually scores poorly at best, or negatively at worst, if we crack down on Roths. It doesn't realistically seem in the cards.
Roth IRA Crackdowns And Loophole Closers May Be Coming, Though
Now, that being said, some crackdowns, I think, are at risk, and actually we've seen a glimpse of these already in things like the recent President's budget proposals of areas where he might crack down on Roths. And there were several in this category that I think actually do have a decent chance of happening at some point over the next couple of years.
Introducing Required Minimum Distributions (RMDs) for the Roth IRA Beyond Age 70 1/2
Number one, adding required minimum distributions to Roth accounts. So the whole dynamic where traditional IRAs have RMDs once you're 70 and a half, and Roths don't, the days are probably numbered for that. We're going to make them work the same way. We'll create parity. We'll say Roths are subject to the same RMD rules as traditional IRAs going forward.
I think there's actually a pretty good chance that happens at some point in the next couple of years. We're going to bring RMDs in. Not because Congress actually gets any money by forcing dollars out of a Roth, since it's still a tax-free distribution. But if they force it out, they get to tax the investment accounts thereafter, because if you don't spend the money and it's just forced out of the account, now it's in your brokerage account or your savings account or somewhere else where it gets taxed in the future. So it's not a huge revenue increase at all, but it's a small one. Classic for loophole closure used to pay for something else.
Eliminating The Stretch Roth IRA
Other areas we're seeing a potential crackdown, eliminating stretch IRAs. This has popped up in the President's budget proposal several times now where we would get rid of stretch IRAs and everybody would be subject to the five-year rule.
You would still be able to do a spousal rollover. If you leave the IRA to a young child, they can wait until they turn 21 or the age of majority, and then they'd be subject to the 5-year rule. And you could leave it to someone similar to your own age and they could stretch, only because they're similar to your age already so it's not really much of a stretch.
But the whole strategy of leaving your IRAs to young kids and have them stretch it out for an 80-year life expectancy, which is hugely popular for a Roth... that one could go away.
$3.4M Cap For New Roth IRA Contributions
The next one we've seen repeated three times now in the President's budget proposals is putting a cap on Roth contributions, that would say once your account balance is over a certain dollar amount. Based on the last round of math, it would be $3.4 million. It's the present value of an annuity over your lifetime at the Section 415 limit.
So we could see that kind of cap put in place. Now, even that rule, it got buzz as "Congress is going to tax your IRA dollars or force the money out." They actually wouldn't. All that proposal says is once your account balance is north of that $3.4 million threshold, no new contributions. That would just be it. So we're still not going to take the money out, force it out, or do anything that would punish it tax-wise. We're just going to say you can't make more new Roth IRA contributions, once you've already racked up an account that's up to $3.4 million dollars.
Eliminating "Backdoor Roth Contributions"
And then the last one that we're talking about cracking down on, is eliminating the so-called backdoor Roth contributions, and the ability to do a Roth conversion of after-tax dollars. That could be eliminated as well. In fact, I think the odds are very good it's going to be eliminated. It would kill backdoor Roth contributions. It would kill the so-called mega backdoor Roth contribution that you do through a 401(k), all with after-tax dollars that get converted. So those provisions could get eliminated.
So I think we're likely to see crackdowns, putting RMDs on Roths, eliminating stretches for Roths, no new contributions to big Roth accounts, and eliminating backdoor Roth contributions. But that's about the extent of it.
Frankly when you look at the legislative trend so far, not only are we not cracking down on Roths, we're actually encouraging them. We have things like the myRA accounts that encourage you to create a Roth for all new people. We've been liberalizing the rules for Roth conversions, making it easier for people to create Roth IRAs. Again, that's because it looks like a revenue increase over 10 years.
A VAT Or Other Consumption Tax To Tax Roth IRA Dollars?
Now, all that being said, I actually think there is some decent chance that Congress will eventually go after the dollars in Roths for taxes. But it's not going to be by income-taxing it.
And to recognize the dynamic here, you've got to look at what drives the tax system so far. We draw taxes from a couple of different areas. A little bit of various types of excise and government fees, we have a corporate tax system, we have a payroll tax system (which is the primary way we pay for Medicare and Social Security), and then we have [individual] income taxes. Those pillars, corporate taxes, income taxes, excise taxes, and fees, are pretty common around the globe. Most developed countries, that's part of their tax policy to use those pillars.
But most countries have a fourth pillar that we don't use here in the U.S., which is a consumption tax, so a sales tax or what's called a value added tax (VAT). You can think of it like a sales tax, but instead of paying at the register, factories pay it when they ship the goods out, because it's harder for factories to avoid taxes. Sales taxes are easy to avoid. You just have a black market of cash and people don't do it at the cash register. So value added tax is the popular alternative.
When you look around the globe, in fact, we're actually one of the only developed nations in the world that does not have a value added tax, or some kind of consumption tax as part of our tax system. So when you look at how this likely plays out in the future, it gets pretty straightforward. We say we will never apply an income tax to the Roth dollars that you've got in your account. Instead, we'll simply hit it at the cash register every time you spend a Roth dollar for the rest of your life. I think that's realistically how it plays out. We don't income-tax Roths. We simply put a consumption tax out there that hits every Roth dollar when you ever spend it. That's the way you tax a Roth without taxing a Roth.
If you look actually at some of the political discussions around taxes in the past just two or three years, you'll notice value added taxes have started cropping up in the discussion, again, because we're one of the only developed nations that doesn't have one. It's a huge tax base. You can apply just a tiny percentage tax, 1% or 2% or 3%. It blends right in. Many states already have sales taxes in the 3% to 7% range, so a couple percent from the federal government would, in theory, kind of blend right into that. That's realistically how it happens.
But the reason that's important is if we ultimately tax Roths because we apply a consumption tax like a sales tax or a value added tax, it still means it was a good deal to put the dollars into the Roth. You still get them income tax free. We don't renege the income-tax-free promise. We just attach the dollars by some other way that we tax the economy in the aggregate. That's realistically how it plays out. The Roth IRA still becomes a good deal even if taxes are higher in the future.
Is It Right To Contribute To A Roth IRA In The First Place?
Of course it has to actually be a good deal for you, which means you contribute to Roths when your rates are low, not universally, not always. You do it when your rates are low. If your rates are high, you're in your peak earnings years, you contribute to a traditional IRA and get your tax deduction. Wait until you retire and your income goes down, then do a Roth conversion and create the dollars. Or do partial systematic Roth conversions to whittle the account down over time.
So I'm not saying it's open-license to do Roth for everyone. Instead actually the whole point is if we eliminate backdoor Roths and we eliminate avoiding RMDs on Roths and we eliminate the stretches on Roths and we do all these other crackdowns on Roths, it's really going to come down to the one driving factor. You contribute to a Roth when your rates are lower, which means you contribute now if your rates are low. If your rates are high now and you think they're going to be low later, you do a traditional IRA or traditional 401(k) now and you take the withdrawal. You do the Roth conversion later. The timing of your taxes between Roth and traditional just becomes more important than ever.
So let me pause there. Any questions about any of this? Are you guys hearing these questions coming up from your clients as well of is Congress going to get rid of the Roth promise, is this thing going to die some day? Does that come up for you? Do you have these kinds of conversations with clients?
Diane says, "Yes, I hear similar questions, agree with you, tell them similar things."
Frankly the biggest one to me that comes up is clients that say, "We have all these deficits, tax rates have to go up," and just pointing out to them, we may gather more taxes in the future, but that doesn't necessarily mean we do it by taxing Roth IRAs, because we can do it with a value added tax. We can raise the payroll taxes on Social Security and Medicare, which is the way we pay for them, and the most straightforward way to close the deficit. We could frankly raise taxes on younger folks, but give preferences for retirement accounts and do that to appease senior voters. So there are lots of ways that this plays out that don't necessarily tax large Roths. That's really the least likely scenario, simply because of political expediency.
So thanks everyone for joining us for Office Hours. Stay tuned next week, 1:00 p.m. East Coast time on Tuesdays. Hope you have a great day. Take care everyone.
So what do you think? Are you or your clients wary about contributing to a Roth IRA or Roth 401(k) out of fear that favorable treatment will be repealed someday? How do you discuss this issue with your clients? Please share your thoughts in the comments below!