Are Roth IRAs at Risk?

Michael Kitces is a Partner and the Director of Wealth Management for Pinnacle Advisory Group, co-founder of the XY Planning Network, and publisher of the continuing education blog for financial planners, Nerd’s Eye View. You can follow him on Twitter at @MichaelKitces.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

I'm joined today by financial planning expert Michael Kitces to look at what the future might hold for Roth IRAs and what it means for investors.

Michael thanks for joining me.

Michael Kitces: Great to be here.

Glaser: Let's start with one of the big questions we get about Roth IRAs, which is: "Will Congress basically repeal the tax-free treatment of these." Is the Roth IRA in trouble over the long term?

Kitces: I really don't see it in trouble. I certainly get the concerns, given the deficit projections. There is obviously not a lot of trust around government in general these days. I really do appreciate the concern. But the idea that the tax-free promise for Roth would just be outright repealed someday, I just don't view as realistic. There are a couple of reasons for this.

One, you get down to simple voting mechanics; politicians like to get themselves re-elected. Seniors are an incredibly powerful voting bloc. They have a rather powerful organization in Washington called AARP that's very protective of things like retirement accounts. Just the political feasibility of pushing something like that through is not very high on the list.

The second challenge that goes with it is the perverse reality of how Congress evaluates legislation--is that most tax legislation gets "scored." They do the projection about how it will impact fiscal revenues over a 10-year time horizon. The weird reality is, over a 10-year time horizon, if they stop people from putting money into Roths and instead drive money into, say, pretax retirement accounts instead, more people get tax deductions now, and federal revenue actually goes down in the near term. The government may get it back in the long term, but it goes down over a 10-year window. And when Congress scores the legislation, it actually looks bad. When you look at the proposals that have been out there, anything that tries to limit or repeal Roth accounts actually gets scored as a revenue loss for the government. They'd have to raise a new tax to pay for eliminating Roths--which doesn't seem realistic. If we're going to figure out how to get a new tax through for anything, killing Roths is not high on any politicians' list. The idea that we're going to raise a tax and then use it to pay for killing a thing that people love doesn't go over very well.

Given those political realities, I don't think realistically we're looking at an environment where the Roth promise gets killed. Now there are other ways that Congress might try to get at the dollars, but just saying, "Roths were tax free for years; we've decided they are not tax-free anymore..." They do have the legal power to do it. Congress could to it. But it just doesn't seem realistic given the true political mechanics of how it would have to get done.

Glaser: Now, you say that there could be some changes, though. They could introduce RMDs for Roths. Do you think that's a strong possibility.

Kitces: I do think there are other crackdowns that have a pretty good chance realistically of coming. And we've actually gotten the roadmap for what many of them would be in the President's budget proposals over the past couple of years. Although budget proposals do not necessarily become law, many of them have actually been proposed two, three, four years in a row and haven't become law yet. It gives you some sense as to where Washington is looking for potential tax law changes and revenue raisers, and there are a couple of Roth items on the list.

Number one is required minimum distributions for Roths. We have this special treatment with Roths: You don't have a required minimum distributions when you are 70 1/2, whereas with traditional retirement accounts, IRAs, you do. I think the odds are actually pretty good that at some point we're probably going to see RMDs for Roth accounts as well. Of course, if you are taking money out of your Roth to spend it for your retirement, you won't care anyway. Either way the RMD still isn't taxable in that year, but what it will do is it will keep people from building up enormous Roths just to leave to the next generation. The RMDs will start forcing the money out. If you don't need it, that's fine. It will end up in your investment account, your brokerage account. But in the future, that's getting taxed and the growth is going to come in. I think that's one way that Congress will get at accounts; we might see the introduction of RMDs.

We also might see a cap where, once you get above a certain account balance, you can't make new contributions. That was proposed in the past. It wouldn't force money out, but it would keep you from adding new contributions in.

And there is even discussion of killing the so-called stretch IRA. When you leave a retirement account, Roth or traditional, to the next generation, they can take the distributions stretched out over their life expectancy. There is some discussion now that we might eliminate the stretch and force everyone to take money out over five years. You can still inherit a Roth, and it will still be tax free, but you are not going to stretch it out over a multi-decade time horizon, as has been the case in today's tax environment.

Glaser: We discussed in the past the backdoor Roth IRA may also be in trouble.

Kitces: Realistically, I think the days are certainly numbered for the backdoor Roth. That's the easiest fix of all.

The backdoor Roth, for those who aren't familiar, is you make a contribution to a non-deductible IRA and then you convert it shortly thereafter, and you might not have been eligible to do a Roth IRA contribution directly because your income was too high. So you do this two-step process that works because there is no income limit on non-deductible IRA contributions. There is no income limit on Roth conversions. That one is probably going to get killed soon. We know what the proposal is going to look like; it's actually very simple. They'll simply say, if you've got aftertax dollars in an IRA or a 401(k), that portion of the money can't be converted. And then the backdoor Roth is gone. Also, what some people call "the mega backdoor Roth," where you do it through a 401(k) plan with aftertax contributions that get converted--that would be gone as well. That one, I think, realistically is only a matter of time. We'll see how long it takes. It could be one year, or it could be five years. But I'd be very surprised if it wasn't gone at some point in the foreseeable future.

Glaser: If Roths are here to stay, but there could be some tweaks, what does that mean for investors who are saving for retirement today. Is there anything they should be doing differently maybe in advance of some of these changes that are potentially coming?

Kitces: There are few takeaways that you get from this. Number one is, there is such a thing as being too excited about a Roth account. In an environment where we might have RMDs, you might lose a stretch, basically Roths are just getting forced back to a point where this isn't meant to be a mega accumulation account, particularly not for multiple generations of your family. It's meant to be an account you accumulate for retirement and then use it in retirement. And that's really what all these tax law changes would be driving us back toward.

So in that environment, where you are looking to make contributions today and you're trying to figure out how to optimize what you're going to spend in retirement and how to balance these accounts out, the rule-making process actually gets very simple. You want to pay your taxes whenever your rates are lowest. So if you are in a lower tax rate right now and you are expecting you are going to be in higher rates in the future, perhaps because of all of the retirement account dollars that you are building up, you want to contribute to a Roth now and get it tax-free later.

If you are in a higher tax rate environment now, which is actually the case for a lot of people in the home stretch of saving--who are in their 40s and 50s or maybe in their peak earnings years--the best thing we can do is contribute to a good old-fashioned traditional IRA or 401(k), get our tax deduction at today's high rates, wait and take out our IRA dollars in the future when our tax rates are lower. Or better yet, contribute to the IRA today, wait 10 years or however long it is until we retire, and our tax rates maybe go down a bit, and then look at doing something like a partial Roth conversion, so that you can chip away at the dollars while the rates are low.

But be aware of those people out there saying, "I'm so concerned tax rates are going to be higher in the future so I'm going to do a massive Roth conversion and convert everything all at once." All you end up doing is driving your tax rate up to top brackets today to dodge something that probably would have been lower rates in the future, and particularly in an environment where even with deficits and all this discussion that "tax rates must inevitably go higher in the future," they don't necessarily have to go higher by raising the income tax rate. We could resolve Medicare and Social Security deficits by raising Medicare and Social Security taxes, which don't impact an IRA. We could introduce a value added tax, a VAT tax, which is like a sales tax on all of our goods--a consumption tax. We're actually the only developed country in the world that doesn't have some kind of sales or consumption tax as a pillar of our tax system. We might introduce one of those.

The end result is your Roth would be still be tax-free. Things at the cash register will cost a little bit more because there is a consumption tax built in. So you would indirectly pay the tax, the government will get their pound of flesh, but your Roth would still be tax-free. And loading up on Roth dollars trying to avoid this future tax rate increase and then finding out that the future tax rate increases are sales taxes, consumption taxes, Medicare taxes, Social Security taxes--you could actually end up with a lot of Roth regret.

Glaser: Michael, thanks for your thoughts on Roths today.

Kitces: My pleasure, thanks for having me.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.