Will Roth IRAs Eventually Become Taxable?

Could Roth IRAs face taxation in the future?

After foregoing the upfront tax benefits of a pretax account for the assurance of tax-free growth, is there a chance the rules could change, making Roth distributions taxable? This thought sends shivers down the spine of those planning for a tax-efficient retirement, especially those contemplating substantial tax bills for converting pretax accounts to Roth IRAs.

When I talk with folks who are planning their retirement, I’ve been hearing more worried talk about Roth taxes. And honestly, I get it. It feels like the rules keep shifting on us.

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For ages, everyone’s been saying, “Put your cash in tax-deferred accounts. You’ll probably be taxed less when you retire.” But now, with tax rates at historical lows, the conventional wisdom is that saving pretax might not be the smartest move. If taxes increase, anyone with a big balance in a pretax account might get hit hard. 

So the latest advice? Instead of saving in tax-deferred accounts, it’s pay your taxes now at these current rates and put your money in a Roth 401K or IRA.

But here’s where the anxiety kicks in: What if the rules change yet again? The growing concern is that, after adapting and moving our savings to Roths, they might flip the script and those Roth savings end up facing taxes. The ever-changing landscape definitely keeps us all guessing and emphasizes the need to stay informed and flexible in our retirement strategies.

Understanding the Specifics: Taxation Mechanics of Roth Accounts

First, it’s important to know that when we are talking about the taxation of Roths, we are not talking about the entire balance. The rationale behind this is to understand the basic mechanics of the Roth. 

A Roth Individual Retirement Account (IRA) is a type of retirement account where you pay taxes on the money going into your account, and under current rules all future withdrawals are tax-free. The appeal of the Roth IRA, compared to a Traditional IRA (where you get a tax deduction for the amount you contribute and then pay taxes on withdrawals), is the potential for tax-free growth and tax-free withdrawals in retirement. Here’s a breakdown of how it currently works:

Contributions: Money you contribute to a Roth IRA has already been taxed, meaning you’re contributing post-tax dollars. There’s no immediate tax deduction for your contributions as there is with a traditional IRA.

Growth: The investments in a Roth IRA grow tax-free. This means that as your investments generate interest, dividends, or capital gains, you don’t pay taxes on those earnings each year.

Withdrawals: Once you reach age 59½ and your Roth IRA has been open for at least five years, you can make tax-free withdrawals. This means both your contributions and the earnings on those contributions can be withdrawn without incurring additional federal taxes.

In this hypothetical scenario, when you withdraw from your Roth IRA, you would owe taxes on the earnings (or growth) portion of your withdrawal, but not on the contributions since you already paid taxes on that money. 

Does Congress Have The Power To Make Roth IRAs Taxable? 

The simple truth is…Congress does have the power to change the tax treatment for Roth retirement accounts. As established by Article I of the U.S. Constitution, Congress has a broad range of legislative powers, including the authority to create and modify tax structures, regulate commerce, and address modern issues through the “Necessary and Proper Clause.” 

So the question of could it happen? Yes, it’s legitimately possible. But…I don’t think a direct tax on the growth of a Roth IRA is very likely. However, I do think there could be some indirect taxing mechanisms added down the line. Before covering those possibilities, let’s cover the reasons why a direct tax on distributions is not likely. 

Why A Direct Tax On Roths Is NOT Likely

Accoring to the Investment Company Institute, There are 32.3 million US households that have a Roth IRA. That’s nearly 25% of all US households. With numbers this large, it’s unlikely that elected legislators would undertake the political risk of reversing the promise of tax free distributions. 

In addition to the self preservation behaviour, another reason that they won’t directly tax a Roth is that the government secretly loves Roth IRAs for a variety of reasons. 

Reason #1: The Government Needs You To Save 
The U.S. government has always shown that they want to help people save for retirement, and they have multiple policies and incentives to help you. The driving force behind such measures is an acute recognition that Social Security isn’t designed to shoulder the entirety of a retiree’s financial needs, replacing only a fraction of pre-retirement earnings. 

Coupled with this is the government’s efforts to mitigate the potential drain on public resources. Without adequate savings, retirees could find themselves leaning heavily on government assistance programs, such as Supplemental Nutrition Assistance Program (SNAP), Medicaid, or housing assistance, further taxing an already stretched social welfare infrastructure. By promoting savings avenues like IRAs, 401(k)s, and Roth accounts, the government is strategically safeguarding its suite of public assistance programs from potential overextension.

Reason #2: The Government Likes Getting Current Revenue
The Roth IRA, from a government fiscal perspective, presents a unique advantage that aligns with the immediate revenue interests of the state. Unlike traditional retirement accounts where contributions are made with pre-tax dollars and taxed upon withdrawal, Roth IRA contributions are taxed upfront, thereby providing the government with immediate revenue. This structure can be seen as particularly favorable to the government, especially in times of fiscal pressure. By encouraging the Roth IRA’s use, the government essentially accelerates its tax revenue timeline, collecting taxes today on funds that, under different retirement savings vehicles, might remain untaxed for decades. In essence, the Roth IRA’s design allows the government to harness present-day revenues, addressing current budgetary needs and potentially hedging against future economic uncertainties.

Reason #3: Less Administration Hassle 
From the government’s viewpoint, the Roth IRA is a neat package. It simplifies the retirement distribution process. Since Roth contributions are taxed upfront, retirees can pull money out tax-free. This means less paperwork, fewer errors, and reduced costs for the government. Plus, by getting their tax revenue at the beginning, the government doesn’t have to worry about people trying to evade taxes later. Traditional IRA accounts might give people a bigger window to use tricky tax evasion tactics, but Roth IRAs shut that window pretty quickly, ensuring the government gets its share.

There Are Hungry Eyes On A Growing Pool Of Money

While I don’t think an outright attack on the tax-free distributions of a Roth IRA is very likely, this doesn’t mean that the money-hungry politicians haven’t taken notice of the growing pool of money that they can’t touch under current law. 

The actions of exceptionally wealthy individuals, like Peter Thiel, have drawn attention to this. For example, Thiel’s strategic use of a Roth IRA began in 1999 when he invested $1,700 to acquire 1.7 million shares of PayPal at a mere one-tenth of a penny each. A few years later, with eBay’s acquisition of PayPal for $1.5 billion in 2002, this stake ballooned to $28.5 million. Thiel, a prominent figure in Silicon Valley, didn’t stop there. He funneled the millions from his Roth IRA into promising startups such as Palantir and Meta Platforms. By 2008, his Roth IRA’s value skyrocketed to $800 million, and by 2019, it had grown to a staggering $5 billion, setting the record for the most valuable known Roth IRA.

The experience of Peter Thiel is certainly not typical. According to Fidelity Investments the average balance of both traditional and Roth IRAs is “only” $113,800. However, Fidelity also pointed out that 59.1% of all IRA contributions going to Roth IRAs. This means they are now more popular savings vehicles than it’s pretax counterpart and as the popularity of Roths continue to grow, this represents the potential for large amounts of income among future retirees to be free from federal tax. So while I would not expect an outright attack on the tax free nature of a Roth IRA, I would expect some limitations on the use of IRAs and even some potential indirect taxes aimed at getting tax revenue on these dollars. 

Potential Future Limitations on Roths

Take a close look at the tax code, and you’ll quickly realize it’s chock-full of unique provisions. A tip for navigating this complex landscape? Watch out for the prefixes “pre-” or “post-“, which are usually tacked onto a date. These prefixes pepper the IRS guidelines, and their presence often indicates that an exception has been made for those who joined a program before any rule changes came into play. If there ever comes a day when Roth IRA withdrawals face taxation, it’s a fair guess that similar special provisions will be put in place.

Given the authority vested in the U.S. federal government, they can easily tweak the rules surrounding Roth IRAs, potentially altering how attractive they are for savers. Here are some potential changes they might ponder to limit participation in Roth IRAs:

Income Limits: The government could reduce the income eligibility threshold for Roth IRA contributions, thereby excluding higher earners from participating.

Contribution Limits: Current annual contribution limits could be decreased, which would mean individuals could invest less money in a Roth IRA each year.

Age Restrictions: The government could implement age restrictions, either limiting younger individuals from starting Roth IRAs or older individuals from continuing to contribute.

Conversion Restrictions: One strategy many individuals use is converting Traditional IRAs to Roth IRAs. The government could place further restrictions or limitations on these types of conversions.

Phase-Out Ranges: Adjusting the Modified Adjusted Gross Income (MAGI) ranges for phase-outs could impact the ability of some to contribute to Roth IRAs.

Limit Types of Investments: Limiting the kinds of investments permitted within a Roth IRA could make it a less attractive option for certain investors.

Withdrawal Rules: The government could make early withdrawal penalties more severe or adjust the qualified distribution rules, potentially making Roth IRAs less flexible.

Cap on Total Balance: There’s been some discussion about placing a cap on the total amount that one can have across all their retirement accounts, which would impact those with significant Roth IRA balances.

Eliminate Backdoor Roth Conversions: Some high earners currently use the “backdoor” method to fund a Roth IRA even if they’re above the income limit. The government could close this loophole. (The Build Back Better Act in 2022 originally had this in it. )

RMDs (Required Minimum Distributions): Unlike Traditional IRAs, Roth IRAs currently do not have RMDs during the owner’s lifetime. Implementing RMDs for Roth IRAs could change their attractiveness.

Left to the imagination of lawmakers, there are likely many more limitations which could be added.

A “Backdoor” or Indirect Tax On Roths

In addition to direct limitations on Roth IRAs, there’s also a possibility of indirect or “backdoor” taxation. A few examples are: 

1) VAT Tax

A VAT is a consumption tax, levied at each stage of production based on the value added to a product at that stage. It’s been pointed out that the U.S. is the only major country that does not have a value-added tax. Other data shows that a consumption tax accounts for as nearly a third of total tax revenue in many countries. 

The key reason the U.S. hasn’t adopted a federal VAT is the existing sales tax regime, where each state, and sometimes cities or counties within those states, sets its own rates and rules. This creates a complex patchwork of sales tax regulations, as opposed to the more streamlined, albeit contentious, federal VAT system employed by many other countries.

However, it’s worth mentioning that retailers already submit sales taxes to the relevant government bodies. The infrastructure is essentially in place to introduce an additional federal sales tax. Such a change would have different implications for Roth account holders.

If a VAT is introduced, funds from a Roth IRA might have reduced purchasing power when buying goods or services. Companies in a Roth IRA could face higher production costs, possibly affecting their stock value and the Roth IRA’s overall worth. This tax might also change consumer habits, influencing various economic sectors and Roth IRA returns. So, even if Roth IRAs aren’t directly taxed under VAT, the tax’s broader effects could still impact the value and use of Roth funds.

2) Alternative Minimum Tax (AMT)

The Alternative Minimum Tax (AMT) is designed to prevent wealthy taxpayers from using loopholes to avoid paying taxes. It requires taxpayers to calculate their tax liability twice: once under the regular tax system and once under the AMT, then pay the higher of the two amounts. Currently, Roth IRA distributions do not factor into the AMT calculation. However, it’s conceivable that future tax reforms might change this exclusion. If Roth IRA distributions were included in the AMT calculations, it could increase the AMT liability for some taxpayers, especially those who take large distributions from their Roth IRAs.

3) Taxes on Social Security Benefits

The IRS calculates the taxability of Social Security benefits based on the combined income of an individual or couple, which includes tax-exempt interest income. While Roth distributions are not currently counted in this formula, the IRS could revise its methodology to include them, similar to how tax-free bonds are considered.

4) Medicare Income Related Monthly Adjustment Amount (IRMAA)

Currently, IRMAA is determined by a person’s modified adjusted gross income (MAGI). Though Roth IRA distributions are not included in MAGI, future policy changes could include them, which might lead to higher Medicare premiums for some retirees.

5) Change in Capital Gains Tax Calculation

Currently, when determining capital gains tax rates, the IRS considers the total income, which includes the realized capital gains. If there were changes in the methodology, Roth IRA distributions could be counted as part of an individual’s income when determining the applicable capital gains tax rate. By including Roth distributions in this calculation, taxpayers might find themselves pushed into a higher capital gains tax bracket. This means that while the Roth distribution remains untaxed, it could indirectly cause other investment income, such as long-term capital gains or qualifying dividends, to be taxed at a higher rate than they would have been otherwise. This method would indirectly subject Roth IRA funds to a tax effect by influencing the rate at which other income is taxed.

An Old Answer Is Still The Best Answer

While there are compelling reasons to believe that Roth IRAs may never face direct taxation, it’s crucial to remain aware. Over the years, the landscape of financial policy has seen many shifts, and though direct taxation may seem unlikely, there’s always the potential for indirect taxation or imposed limitations on these accounts.

However, this uncertainty underscores an age-old adage in financial planning: diversification is key. As we navigate the complexities of preparing for retirement, it’s essential to remember the rule of threes when it comes to savings. Every individual should ideally maintain three distinct savings buckets: a pre-tax account that offers initial tax deductions and deferred taxation upon withdrawal, an after-tax account that offers flexibility and tax benefits for capital gains, and a tax-free account, like the Roth IRA, that promises tax-free withdrawals in retirement. By diversifying your savings in this manner, not only do you prepare for any potential tax changes but also ensure a balanced and resilient financial future.

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