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Time to Fix a Fiscal Mistake

Last week, the U.S. House of Representatives approved a Roth alternative in the Thrift Savings Plan for government employees. Roths are the antithesis of sensible tax and budget policy. Rather than expanding them to federal employees, Congress should scrap them.

As most of us know, there are now two choices in both IRAs and 401(k)s. With a traditional IRA or 401(k), the contribution is not taxed when made, but distributions from the retirement plan are taxable. In both Roth IRAs and Roth 401(k)s, the contribution is taxed in the year that it is made, but distributions are tax-free.

The advantage of either alternative is the same -- the elimination of tax on investment income. The difference is when the money is taxed.  This may seem like a minor difference, but the amount of money that you can accumulate tax-free can be greater in a Roth.

The difference between the effective contribution to a Roth and traditional IRA/401(k) is in fact much greater for those in higher tax brackets. I have written about the drawbacks to Roth IRAs and Roth 401(k)s before, in the journal Tax Notes ("I Want a Roth IRA for Xmas," December 21, 1998, p. 1567, and "Fun and Games with the Roth IRA," July 10, 2006, p. 167.)

Roths also offer other advantages to higher-income taxpayers; most importantly, unlike the traditional form, they do not require withdrawals at age 70 ½. This means that the money in Roths can be accumulated until death and passed on to heirs tax free.

The problem is that Roths further tilt the tax advantages of retirement savings in favor of the higher income while hiding the revenue loss of doing so. This means even less revenue for the federal government by allowing mostly higher income taxpayers to enjoy more tax-free earnings at the expense of all taxpayers.

The fact is, Congress was not focused on choice when it originally created the Roth alternative. Its goal was to hide the cost of traditional IRAs to the federal budget. Since the contribution is taxed when it is made, the loss of revenue to the Treasury is hidden until the money is withdrawn in the future, usually far beyond the five- or 10-year periods used for federal budget estimates.

Even more outrageous, budgetary sleight-of-hand enabled Congress to pretend that they actually raised revenue by creating Roths. Thus, many taxpayers were given the option of converting a traditional IRA into a Roth. Since they had to pay income taxes in the year of conversion, this temporarily increased the amounts collected by the Treasury.

The situation will get worse next year. Until now, Roth conversions are only allowed for those whose adjusted gross income is $100,000 or less. In 2010 everyone can convert, and higher-income people almost certainly will. Although taxes will be paid earlier, this will actually be a tax cut for the affluent, and will make our future budget picture much worse. Even a recent article in SmartMoney magazine, which sings the praises of Roth 401(k)s as a boon to individuals, acknowledges that these conversions "may well be bad policy" and will certainly have a long-term negative impact on our economy.

If we are truly moving toward budget transparency and have any hope of simplifying our income taxes, Roth's should not be expanded to federal employees. Instead, Congress should:

  1. First, eliminate the ability to convert to a Roth. Or, if such conversions are allowed, require that the tax liability be paid from the IRA. In either case, no revenue gain should be claimed in the federal budget.
  2. Second, the age 70 ½ mandatory distribution requirements for traditional IRAs and 401(k)s should apply to Roth IRAs and 401(k)s.
  3. Third, there should be one form of IRA or 401(k). I would keep the traditional IRA, but, if policy makers prefer a Roth, the revenue loss should be accounted for in a way that the true long-term costs are shown.

If these steps are not taken, budget games will continue to interfere with sensible fiscal policy.

Comments

Actually, Roth 401(k)s are required to follow the required minimum distribution regulations found under Code section 401(a)(9).

Most ROTH IRA conversions were made at higher values than today, so the Treasury has gotten a windfall with the early collection. Now that the stock market is down, I don't hear the Treasury wanting to undo any of those conversions and give the money back.

Your real complaint is that the Treasury spent the tax money as soon as it collected it. If it had saved the money, the ROTH conversion is tax-neutral or in favor of the Treasury, unless the IRA owner scores big with investments, or unless the government raises rates substantially.

I've not been a fan of ROTH conversions precisely for the reason that it's usually bad planning to pay large taxes decades earlier than necessary.

Is it not the case that paying the tax due on Roth conversion from the IRA adds a 10% excise tax to the amount used to pay the tax? There may be circumstances in which the tax could be avoided, principally if the taxpayer is old. But a young high-paid attorney with a healthy zest for tax avoidance would not much appreciate the Treasury adopting a requirement that imposes an excise tax in exchange for compliance.

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