Relax, Your Roth IRA is Safe

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

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Image: dcbprime/Flickr

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.

Megan McArdle: How Safe Is Your Roth IRA?

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.

Withdrawals from non-Roth retirement accounts--accounts that make up by far the largest piece of the retirement asset pie--will be subject to the all but inevitable increased income tax rates in coming years. If Congress wants to get a lot more revenue from taxpayers' retirement assets, this is the way it will likely happen. (This is fair play, as it is part of the gamble that investors made when contributing pre-tax dollars to the retirement accounts in the first place and then enjoying the benefits of tax deferral on the earnings. Those benefits will probably still make 401Ks and IRAs a good deal over the long run.)

Will Americans keep investing in tax-favored retirement accounts and should you? President Obama thinks so. His 2012 budget includes a proposal requiring small employers to automatically enroll employees in IRAs at a default contribution of 3%, and offering the employers a tax credit to do so. Unsurprisingly, the Republican budget also maintains favorable tax treatment for retirement accounts. Tax incentives to encourage Americans to save will not go away.

If higher future tax rates make your money worth more today than tomorrow, paying off fixed costs today (such as your mortgage) could be a good idea if you expect those fixed costs will continue in the future (i.e., you will continue to live in the house). This will have seemed an especially wise maneuver if the mortgage interest deduction is eliminated, scaled back, or turned into a more limited tax credit--likely options, because though considered politically sacrosanct for many years, this deduction loses the government an enormous amount of revenue.

The bigger question is: What will earn the highest rate of return? Historically, stocks beat real estate handily. If you're unusually lucky and your house does appreciate in value, any gain past a certain threshold is taxable. If gains in the stock market during the next decade make up for the losses in the last, but your house value remains stable, you may not mind paying tax on your retirement gains. After-tax return on a high yield is still better than zero tax on zero gains.