Financial Planningretirement

The Future of Roth IRAs

If you’ve ever spent any time on a personal finance blog, you’ve likely come across one, or two, or twelve articles comparing the Traditional IRA to a Roth IRA.  (If you haven’t, congratulations on finding more interesting things to read about!)  At the time of this posting, for example, a Google search for “traditional vs Roth IRA” yields approximately 94,600 articles.

So rather than walk through the usual IRA material (although we do provide a quick summary to get you up to speed), in this post I wanted to discuss future potential changes to the tax treatment of Roth IRAs.  Over the years, I’ve had several people raise concerns about contributing to Roth IRA accounts, fearing that the “tax free” treatment of the accounts may be taken away in the future.

Long story short, I think it’s unlikely that Roth IRAs will be taxed in the future, and it shouldn’t stop you from contributing to one today.  While it’s certainly possible that some of the details will change over time, Congress has very little incentive to change the tax treatment of these accounts.

What is a Roth IRA, exactly?

I know the legal and tax structures of retirement accounts isn’t the most fascinating topic (at least for some of us!), so I’ll keep this short and sweet.  If you’re looking to save for retirement outside of your 401(k),  you have two account options to choose from: a traditional IRA and a Roth IRA.  What’s the difference between the two?

  • When you pay tax on your savings-  all retirement accounts have some tax advantages built into them, but you need to know how the taxes work to make the best choice.  With a traditional IRA, you receive tax advantages in the beginning; the money you contribute to the Traditional IRA isn’t taxed this year, and it grows tax-deferred in the account until you retire.  But, since you didn’t pay taxes on the money now, you’ll pay income tax on all the money you withdraw from the IRA when you retire.  Roth IRAs have the exact opposite tax advantages; you pay income tax on the money you contribute to the account now, but the growth and withdrawal of money in the account is tax free when you retire.
  • Income limits- There are a few restrictions placed on both types of accounts.
    • If you make “too much money”, you can’t directly contribute to a Roth IRA.  The IRS website is the best place for a complete list of details on these limits (and the other bullet points on these lists), but as a starting point, your ability to contribute to a Roth IRA in 2018 starts to phase out when your income exceeds $122,000 for single taxpayers and $193,000 for married (filing jointly) taxpayers.
    • This limitation isn’t in place for Traditional IRAs, but your ability to deduct your contribution may be reduced or eliminated if you or your spouse have a 401(k) (or similar) plan at work.  Again, you can refer to the IRS website for the complete set of details.
  • Flexibility– The Roth IRA is a more “flexible” account to work with than the Traditional IRA.  For example, while most early withdrawals from a Traditional IRA are taxed and penalized, you can withdraw your contributions (as opposed to the investment earnings) of your Roth IRA without penalty.
How to Decide if You Would Be Better Off With Roth

When deciding between these two types of accounts, the main driver of your decision should be based on your tax rate.  Simply put: if your tax rate now is higher than you expect your tax rate to be when you retire, a Traditional IRA is probably the right choice for you.  Take the tax deduction now while your rate is high, and pay taxes at the lower rate when you retire.

On the contrary, if your tax rate is relatively low right now, paying taxes right now and getting the tax free income in retirement is likely the better deal for you.  This makes the Roth IRA a particularly compelling choice.

Remember, though, it’s not enough just to look at today’s tax rates to make this decision.  You need to think through how you expect the tax rates themselves to change over time.  Just because you expect to have lower income when you retire than you do now doesn’t mean that your overall tax bill will be lower if Congress raises the tax rates over the next few decades.

Ultimately, this is a decision you need to make based on your overall financial situation.  But in my view, given that tax rates are at historically low levels right now, I think it’s likely that tax rates will rise between now and when we retire, making Roth IRAs a good deal for most low- to middle-income millennials.  (Keep in mind, though, that I don’t think the same way that Congress does – thankfully! – so this is purely my opinion, and not a specific recommendation.)

Will Congress Kill the Roth IRA?

Roth IRAs are fairly popular (as far as financial topics go…) with people in our generation.  Nevertheless, I often get questions about whether or not the Roth IRA will actually be tax free several decades from now when we retire.  Will Congress really honor the promise of the Roth IRA?

In my opinion, yes, they will.  I completely understand the concern that the Roth IRA may be taxed in the future, but I think it’s highly unlikely. Here’s a few reasons why:

Politically, it would be extremely difficult. The people who would be affected the most by a tax on Roth IRAs are the elderly and the retired, who also happen to statistically be the most dedicated voters in this country.  There’s a reason that proposed changes to Social Security and Medicare almost always fail; retirees vote, a lot.  The AARP is one of the most well-organized lobbying groups in the country, and any law change that negatively affects retirees will be met with strong resistance.  Simply put, this isn’t a winning issue for Congress to take up. 

Congressional math is silly.  I probably shouldn’t pick on Congress as much as I do in this post… but they just make it so easy.  Because here’s the thing: the way Congressional legislation is reviewed, taking away the tax benefits of Roth IRAs will actually decrease the amount of taxes collected.

Intuitively, this doesn’t make sense.  Why would taxing a tax-free account decrease tax revenue?  Because of the system that Congress uses to evaluate budget bills.  The Congressional Budget Office uses a 10 year future projection to evaluate the tax impact of the bills it passes.  And in a relatively short time period like ten years, eliminating the Roth IRA would decrease the amount of tax revenue the government collects for two reasons:

  • People don’t take a lot of money out of Roth IRAs every year, so the overall projected tax increase is relatively small.
  • On the other hand, a lot of people contribute to Roth IRAs today… and remember, you’re taxed on the income that you put into a Roth IRA.  If Roth IRAs are eliminated, this savings will be redirected to tax-deferred accounts like the Traditional IRA or 401(k), which will decrease the amount of taxes the government collects now.

Over the long run, eliminating the Roth IRA would increase the amount the government collects in taxes.  But, Congress only evaluates the effects of tax legislation on a ten year time horizon… which means that if they were to pass a bill eliminating the Roth IRA, they’d be passing a tax cut bill, not a tax increase.

Silly?  Absolutely. Good for the Roth IRA?  Yes.

It is much easier to use Roth IRAs now than it ever has been before. Not only has Congress not made moves to eliminate the Roth IRA, they’ve technically made it easier to contribute to a Roth IRA.  Indeed, over the past several years, Congress has passed legislation allowing you to “convert” your traditional IRA into a Roth IRA, potentially allowing people over the income limits mentioned above to contribute to a Roth IRA indirectly.  This is a good strategy for certain individuals, but it’s a complicated process that shouldn’t be attempted without consulting a financial planner or tax professional.  But, it goes to show that Congress isn’t making it harder for you to access a Roth.  On the contrary, it’s easier now than ever before.

If we look at all of these factors, it becomes pretty clear that taxation on Roth IRAs is not a likely scenario in the near future. If you think a Roth IRA is the right choice for you, don’t let fear of future tax law changes hold you back.

Planning For the Future

That being said, there are a few different possibilities of legislation that could feasibly happen in the coming years affecting Roth IRAs, but none of them are reason enough to deter you from using the accounts.

The first possibility is the implementation of some sort of required distributions on Roth accounts in the future. Under the current tax law, you need to start taking distributions from a Traditional IRA when you turn 70.5 years old (because making it an even “70 years old” would have made too much sense…), but you don’t currently need to do this with a Roth IRA.  It wouldn’t surprise me if Congress implemented mandatory distributions from Roth IRAs at some point in the future… but that’s not a reason to not contribute to one.  

Another possibility is for Congress to implement a maximum amount of money that can be held in a Roth IRA. By restricting the amount that can be held in a Roth IRA, the government could prevent you from contributing to a Roth IRA in the future… but as I mentioned before, Congress doesn’t have a strong incentive to do so.  And again, this isn’t a reason to avoid contributing to a Roth IRA today.

Making a Contribution

Once you decide which account to use, it’s time to put money into your IRA of choice.  And if you happen to be reading this article between January 1 and April 15th of any given year, you have an additional choice to make.

Currently, there are caps on how much money you can put into IRA accounts – both traditional and Roth – each year. These caps were relatively steady for a few years, but there’s been an increase from 2018 to 2019; last year you could put $5,500 per year into an IRA, and now you can put $6,000 starting in 2019.  (Once you turn 50, you can add an extra $1,000 to your IRA each year).

But, you have until Tax Day (April 15th, or the next business day if it falls on a weekend) to make your contribution for the prior year.  So, as I mentioned, if you are reading this article at the beginning of the year, know that it isn’t too late to make an IRA (Traditional or Roth) contribution for last year!

If you want help figuring out which type of IRA is right for you, or need retirement savings advice in general, don’t hesitate to reach out! I would love to set up a free introductory phone call with you to walk you through what you need to know.