Relax, Your Roth IRA is Safe

Don't make major financial decisions based on hypothetical future tax policy changes

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Given our budget problems, nearly everyone agrees that the federal government must ultimately collect more in taxes, whether by raising rates, closing loopholes, or some combination thereof. Tax increases would likely affect all types of earnings -- from salaries to investment income. The 3.8% Medicare surtax on "unearned income" of high income taxpayers (which effectively raises the long-term capital gains tax rate from 15% to nearly 19% on most investment assets) is scheduled to take effect in 2013, and it is a harbinger of things of come.

Does this mean you should reconsider your investment strategies? Almost certainly no. Making major financial decisions based on hypothetical future tax policy changes is risky and would be particularly unwise if done to anticipate changes in the tax treatment of IRAs.


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Retirement investment accounts have long enjoyed tax-favored status. Within certain limits, taxpayers may contribute pre-tax dollars to retirement accounts and wait to pay tax on the earnings until retirement. This is an especially good deal if your tax rate is higher during your high-earning working years than during your retirement. Roth IRAs, like section 529 plans designed to save for higher education, are taxed differently. Participants use after-tax dollars to contribute, but can then withdraw all future appreciation tax-free. Washington might be tempted to look for additional revenue in 401(k)s and IRAs, which make up 40% of the stock market's trillions in value, but it's extremely unlikely that Congress will go after Roth IRAs. This would obviously be unfair to those who made the choice to lock up their money under the promise that future earnings would be tax free.

That something isn't fair is no guarantee that it won't happen. But Congress has bigger fish to fry than Roth IRAs. The wealthiest 1% of Americans own more than 40% of investment assets. The maximum Roth IRA contribution is $5,000 per year, and those making more than $122,000 per year are ineligible (not a particularly enticing target for even the most tax-happy politician). While it's true that taxpayers may now convert ordinary IRAs into Roths regardless of income, the hefty associated tax bill and time value of money (having the opportunity to invest the money that would have been paid in taxes) makes this a bad deal for most other than the very wealthy, even in light of the future tax-free appreciation. Though the Los Angeles Times recently described Roth IRAs as a "federally sanctioned tax shelter," the wealthy and their advisers can come up with even better shelters, such as the tax deferral enjoyed on compensation paid in the form of employer funded life insurance policies and stock options. Tapping into these sources or reimposing income limitations on the ability to convert traditional IRAs into Roths would generate far more income than taxing Roth withdrawals.

Similarly, deferral of tax on income and gains in non-Roth retirement accounts will also continue. Right now, investors withdrawing money from retirement accounts prior to retirement age must pay a significant penalty tax. But if Congress decided to tax the earnings on retirement accounts on a current basis, it could hardly also force taxpayers to keep the money locked up in retirement assets. The 40% of the stock market's value held in retirement accounts is there thanks in no small part to their tax-favored status. Eliminating these tax benefits would prompt many investors to withdraw their retirement money and find something else to do with it, which would devastate the market. Some experts are already worried about a looming stock market crash in 2016 and 2017, when huge numbers of baby boomers will turn 70 and be required by tax rules to begin taking minimum distributions from their retirement accounts. Washington certainly won't want to exacerbate this by provoking additional withdrawals from retirement accounts.

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Jennifer M. Kowal is clinical professor of law and director of the tax LLM program at Loyola Law School, Los Angeles.

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