How many times have you read that Roth accounts will be “tax free forever?” Alas, forever is a very long time, and also not a word much used by adults, outside of church. So consider this post a kind of apostasy. It may cost you your faith in Roth.
The present income tax system is less than 100 years old, and has been overhauled and reworked again and again. The idea that today’s Roth provisions will never be changed for the worse, for the rest of your life, and the life of your heirs, suggests an attitude more of faith than reason (“Congress wouldn’t dare!”), and a naiveté that would be touching if it wasn’t so dangerous to your financial well-being.
For your enlightenment, let me review some of the many ways a future, more impecunious Congress might renege on that promise of tax free forever.
Stupid trick #1: Congress decides to include Roth distributions in the definition of “modified adjusted gross income.” This will affect the taxation of your social security benefits and determine how much of the Medicare B expenditure you must bear. The effect is to tax Roth distributions surreptitiously. This is the easiest trick to imagine because Congress has already pulled off exactly this heist in the case of “tax-free” municipal bond interest.
Stupid trick #2: Congress revokes the tax free status of Roth distributions after the death of the initial Roth account holder and spouse. This trick will come into play once enough people attempt to “Parlay Your IRA into a Family Fortune.” At that point, some politician will seize the opportunity to demagogue inherited Roth beneficiaries as the Paris Hiltons of their day.
Stupid trick #3: Congress imposes an excise tax on excess Roth accumulations—amounts over $1,000,000, say. This trick is easy enough to envision, because until a few years ago, just such an excise tax was applied to pre-Roth retirement accounts. Congress will look voters in the eye and say: “no, no, we’re not taxing your Roth—all you have to do is take a big enough tax-free distribution each year to keep your account balance below the excise tax threshold.” But to take a Roth distribution you don’t need is to expose that capital and its future returns to taxation once again—many years short of forever.
Stupid trick #4: Congress sets a deadline, after which excess distributions from a Roth account—more than $100,000 per year, say—will be included in ordinary income and taxed at your regular tax rate. Once again, the rejoinder will be: “No, we’re not taxing your Roth—just take a big enough tax-free distribution before December 31st of the year this legislation passes.”
What makes stupid tricks #3 & #4 so credible is that it is easy to imagine the Zeitgeist in which they would form a winning political combination. On the stump, the rhetoric will sound like this: “My fellow Americans, the purpose of the Roth was to help small savers achieve a more comfortable retirement by easing their tax burden later in life as they spent down their savings. We never intended it to be used as a perpetual shelter for obscene accumulations of dynastic wealth!” Such legislation could easily pass, since very, very few voters would feel the sting of these excise taxes—the average accumulation in traditional 401k plans today is less than $100,000.
Stupid trick #5. Once enough money accumulates in Roth accounts, Congress may simply tire of seeing such enormous amounts of wealth exit the tax system for lengthy periods. The most straightforward response would be to sunset the Roth. Congress could simply declare that all Roth accounts will revert to traditional tax-deferred accounts on the last day of the year, with a cost basis equal to their market value on that day. After that date, any further appreciation would be taxed in the normal way once distributed. The beauty of this change is that projections would show it raising enormous revenues over the long term, while allowing the Congress to maintain, “We never levied one penny of tax on your Roth—just close it out this year.” Roth accounts would never have been taxed—they would simply cease to exist.
Stupid trick #6: Assume tricks #1-#5 never occur. Instead, a resurgent Republican, libertarian consensus carries the day, and President Steve Forbes shepherds through Congress a new flat tax system with a rate of, say, 19%. Hallelujah! This would be the promised land for high income contributors to traditional, tax-deductible, tax-deferred IRA and 401k accounts. After deducting their contributions at Federal and State combined rates of 40-45%, while working, they would, once retired, face a tax on their distributions of only 19%. The Roth believer, by contrast, would have paid those same taxes of 40-45%, on conversions year after year, to be free of paying tax at 19% later. Ouch!
In short, an individual allocating a $24,000 annual 401k contribution on the supposition that Roth funds will be tax free forever is making an enormous bet, over a very lengthy period, that no future Congress, however feckless, will ever engage in any of the shenanigans just described. When only Roth IRAs existed, with contributions limited to $2000 per year in 1998, this was not a very large bet, even if it did go bad. But today a 50 year old committing to a Roth 401k is betting as much as $360,000 in nominal dollars, between now and full retirement age; and a 40 year old is betting just over $500,000. That’s a lot of money to wager on the shaky proposition that dozens of future Congresses will always behave themselves around the Roth.
As any gambler will tell you, the expected return on a bet is the dollar gain or loss associated with each possible outcome, weighted by the probability that each outcome will occur. Please apply this calculus next time you run a web calculator that purports to show whether a Roth 401k is superior to a regular 401k in your own case. I hope to have convinced you that the tax free forever outcome assumed for the Roth by these calculators cannot be weighted as 100% probable.
If I were in my sixties, and contemplating a Roth conversion that I expected at some later point to distribute and spend while alive, I might weight tax free for the rest of my days at 80% probable. If you are in your thirties, and give tax free forever a weight greater than 50%, then I advise you to be on the alert for bridge salespeople. You are too credulous. Your faith in the forbearance of conniving politicians is badly misplaced.
So by all means, make use of those handy web calculators comparing Roth to regular 401k plans. But don’t weight the initial result by 100%. Especially if you are young, consider spreading at least 50% in probability across the six stupid tricks named above, and then calculate the expected return advantage, if any, of the Roth alternative. (And don’t forget to compute the net present value of same.)
I for one am happy to accept the $10,632 subsidy that Uncle Sam and Uncle Cal together offer, right now, to defray my $24,000 annual contribution to a traditional 401k type plan. I’d rather that bird in the hand; I refuse to bet my retirement on a Roth account whose payoff depends on the future rectitude of the sixteen Congresses, and eight Presidential administrations, that I can expect to endure before passing away. I’ll take my chances with taxes ten years hence; I don’t believe the covenant of tax free forever can hold.
*A version of this post previously appeared in Barron’s magazine on March 5th, 2007.
Be First to Comment