Taxes on Roth Accounts???

[am_vanquish]

Based on a post jIM made in another thread ... I felt like expanding on this a bit but didn't want to hijack the other thread where jIM was providing some incredible advice.

1) Tax breaks now are better than promises later (401k is now, Roth is later). If you put all eggs in Roth basket, its possible a politician pisses you off in 20-50 years and taxes the Roth.
...
5) Its best to spread money around (some tax sheltered, some tax free, some taxable) so you can take advantage of certain tax laws. Even if you do not know the tax laws now, having money spread around will help.

As a 20-something just beginning my career (in low tax bracket, for another year or two) and fiscal conservative (appalled at current gov't spending and terrified of future ramifications), I'm a strong believer in the benefits of Roth accounts. Currently, I fund a Roth 401k to maximize my employer's match (100% of 6%), then max a Roth IRA. The only "diversification" of tax liability in my retirement accounts is the 6% match my employer provides, which has to go into a traditional 401k.

Now, I see the value of reducing your AGI if you're on the verge of entering the next tax bracket (DW and I will probably have to do this when she graduates nursing school), but I don't really see how politics should affect the Roth/Traditional decision.

I just don't understand how a politician could tax Roth accounts on a retrospective basis. Sure, maybe they could remove some tax incentives going forward (which would change my idea of an optimal strategy), but they can't renege on their commitment to not tax the $$$ I've already contributed. Am I missing something here? jIM's almost got me ready to go change my 401k contributions to a traditional account ...

[disneysteve]

I think Jim's advice to spread money around is good because there are pros and cons to each type of account when it comes time to withdraw money. I do not, however, share any concern that they will suddenly start taxing Roth withdrawals. Sure, it can happen. Anything can happen. I just don't think it will.

Just to clarify something, though, they couldn't tax your contributions. You've already paid tax on that money. They could only tax your earnings.

[ea1776]

I tend to favor a Roth over ANY other account type (due to the future tax advantages) unless you have a 401(k)/traditional IRA with one of the following:

1. A match
2. In a high tax bracket

The current US trend is to increase taxes. I like the idea of not having to worry about tax increases. I would want to leave the US all together if Congress passed a bill to tax already earned Roth IRA gains. That's just downright unfair to people who played by the rules.

[jIM_Ohio]

We all like the promise of the Roths, but keep in mind at one point politicians used SS money to pay for bombs, and also decided no american should legally possess beer. Do you trust them to make good decisions?

SS earnings are taxed on your paychecks. If your retirement income is higher than 44k I believe, that SS and other income you report is taxed again.

I doubt the tax free status of the Roths is removed, but its possible it gets manipulated.

The way around it is to liquidate all your Roth assets the year before the new tax law takes effect and avoid the tax.

Roth will cap out before traditional tax deductions phase out, and if you read the rest of my post in the other thread my advice was to

a) stay in 15% bracket as long as you can
this implies using Roth in 15% brackets and deductable investment accounts when in 25% brackets. By time you hit 28% bracket, the Roth gets phased out reasonably fast anyway.

b) diversify your taxes
the advice I gave the poster was to use some 401k and some Roth- that advice was specific to a given situation... in your situation that same advice is much different... you are putting all your eggs in the Roth basket, when common sense for many of us is to diversify your investments from a tax perspective.

[southerndoc]

When people say that your Roth might be taxed in the future, it's highly unlikely that it will be directly taxed. Here's the future tax scenarios as I see it (in my lowly opinion):

1. We transition to a consumption tax. Income tax is eliminated, but there is a consumption tax similar to the FairTax or VAT type system. Roth accounts would not be taxed, but when you go to purchase items you will pay the consumption tax on items purchased (23% of purchase price). A traditional IRA, SEP, 401(k), 403(b), etc. has not been ever taxed. In a situation like this, it's likely that you will pay a distribution tax (which is what it's called since an "income" tax has been eliminated) on any distributions from your non-Roth accounts.

2. Income tax remains. Roth accounts are not taxed. Traditional IRA's are taxed as current law allows. Tax rates will likely be higher in the future, so if you're at 28% now, you might be paying 33% in the future. All to pay off the spending of our Congress.

3. A combination of 1 and 2 occurs.

I believe that eventually we will go to a consumption tax in order to maximize taxes for the government while minimizing the ability to dodge taxes. (This will not raise taxes on the poor, contrary to popular belief, thanks to prebates - read about it in a book, online, etc.)

As you can probably gather, I'm a FairTax supporter, and I believe (hope at least) that we will adopt this system in the future. Roth accounts won't be double taxed directly, but they will essentially be treated as regular investment accounts. Regular investment accounts, savings accounts, etc. won't be taxed as the income tax would be eliminated.

[am_vanquish]

I guess I jumped the gun a bit ... good thing I didn't already change my contributions. Last night I calculated the % of retirement savings in Roth vs. Traditional accounts and the employer match in the Traditional 401k is about 15% of my total retirement savings. If I stay where I'm at (income, employer match, etc.), I'd expect that number to decrease over the next 10 years or so, then slowly creep back up after my salary reaches a point where the employer match exceeds Roth limits. From a long-term tax-liability perspective, does that seem inadequate to you guys?

Southerndoc's explanation of the consumption tax helped me realize how the tax law can be manipulated. jIM, is that the type of thing you were alluding to when saying the tax free status of Roths likely wouldn't be removed, but manipulated?

Still, I don't see how the consumption tax makes Traditional accounts more advantagous than Roth accounts ... unless the "distribution tax" on Traditional accounts is significantly less than the would-be income tax (which I could see: if the gov't is getting more tax revenue from consumption, they don't have to hammer retirement savings quite as hard).

[ea1776]

Still, I don't see how the consumption tax makes Traditional accounts more advantagous than Roth accounts ...

Me either. I don't think it would.

As far as Roth vs. 401(k) argument, I love Jim's advice on paying attention to tax bracket and going from there.

[am_vanquish]

Me either. I don't think it would.

As far as Roth vs. 401(k) argument, I love Jim's advice on paying attention to tax bracket and going from there.

I agree, and I mentioned before that DW & I might be very close to the following scenario in just a few years (jIM's work from the thread that inspired this question) ...

If your AGI approaches 68000 (68000 is in the 15% bracket, 68001 is in the 25% bracket), you want to lower AGI and stay in 15% bracket as long as reasonable.

In this situation, we'd re-route just enough of our contributions to Traditional in order to stay at 15% ... but no more. Heck, we might not even do that if we can reduce the AGI by other means, such as HSA.

[Beppington]

Regarding the possibility of taxing something that wasn't taxed before: Here in FL we used to have an "Intangible Personal Property Tax" on stock/ fund investments (applicable only if the value was over $80K I think it was). There was a time when we didn't have it, then we did, now we don't again (Our governor Jeb Bush (Republican) repealed it 1/1/07).

It was a tax on only those that were conscientious enough to put away $ for their future. How is that fair/ reasonable??

Anyway ... certainly Roths could be taxed in this kind of way in the future, a way in which they're not now ... just an example of how the b@stards could do it.

[disneysteve]

Beppington, the city of Philadelphia used to have a tax like that (they still might, not sure - don't live there anymore). You had to report your investment holdings and pay a tax on their value on 12/31. It didn't matter if you had made money or lost money. You paid the tax just because you owned the investments.

[southerndoc]

I don't think traditional IRA's would be advantageous if we went to a consumption tax. I was just saying that I believe you would still have a distribution tax with a traditional IRA in addition to paying a consumption tax. With a Roth, you wouldn't have any and your money would only be taxed twice by the consumption tax.

[KTP]

So person A has a $1,000,000 painting in their house and pays 0 tax on it's value each year, and person B has $50,000 in a CD and has to pay a tax on it's value each year? (not talking about interest or appreciation, just the value tax you seem to be indicating)

How could this possibly be considered at all fair? I mean it isn't even CLOSE to being fair. What about the fellow who buys gold or coins or stamps...wouldn't a tax system like this require the gov. to come into your house and audit everything (including what you have buried in a jar in the back yard) so they could fairly value tax everyone?

Beppington, the city of Philadelphia used to have a tax like that (they still might, not sure - don't live there anymore). You had to report your investment holdings and pay a tax on their value on 12/31. It didn't matter if you had made money or lost money. You paid the tax just because you owned the investments.

[disneysteve]

So person A has a $1,000,000 painting in their house and pays 0 tax on it's value each year, and person B has $50,000 in a CD and has to pay a tax on it's value each year? (not talking about interest or appreciation, just the value tax you seem to be indicating)

How could this possibly be considered at all fair? I mean it isn't even CLOSE to being fair. What about the fellow who buys gold or coins or stamps...wouldn't a tax system like this require the gov. to come into your house and audit everything (including what you have buried in a jar in the back yard) so they could fairly value tax everyone?

Yep. That's exactly how it worked for years in Philadelphia. I do believe they eventually eliminated that tax but I think it was only after a court battle ruled it inappropriate. As I recall, bank assets didn't count. Only investments like stocks and mutual funds, but I don't remember all of the details. I just remember being glad when we moved out of the city and didn't have to deal with it anymore.

[Downfall]

It may be theoretically possible to tax the earnings on Roth IRA's. Barring a massive shift in American politics, however, it's highly unlikely that anybody would set out to antagonize retirees. There is no group in American politics that is so widely perceived as sympathetic, votes at such high rates, and has such adept interest groups. Witness what happens when anybody proposes making any alterations whatsoever to Medicare. It's definitely a good idea to spread around your investments, but the risk you should attach to a retroactive change in IRA Rules is minimal. I'd rate it a more plausible risk than the treasury defaulting on its bonds or the FDIC not paying out on a valid claim, but not much more.

[GrimJack]

I tend to favor a Roth over ANY other account type (due to the future tax advantages) unless you have a 401(k)/traditional IRA with one of the following:

1. A match
2. In a high tax bracket

The current US trend is to increase taxes. I like the idea of not having to worry about tax increases. I would want to leave the US all together if Congress passed a bill to tax already earned Roth IRA gains. That's just downright unfair to people who played by the rules.

Actually, the trend lines for taxes are down.