The U.S. Government’s budget crisis has many people speculating that Roth IRA withdrawals might somehow be taxed in the future. Under current tax law, as long as the Roth IRA participant is at least 59 ½ years old and his plan has been established for at least five years, all withdrawals—including income earned on contributions—can be withdrawn income tax free. (Learn more about Roth IRA taxes.)
The rationale for speculation over taxing Roth IRA withdrawals is that such a tax break may be far too generous in an era of runaway federal deficits. Other tax sheltered retirement plans, after all, are merely tax deferred–meaning you’ll pay taxes on them eventually; Roth IRAs are effectively tax exempt once you pay tax up front on the contributions.
5 Reasons Roth IRAs Will Not Be Taxed
But as much as taxing Roth IRA withdrawals may seem inevitable at some point, there are at least five reasons it probably won’t happen.
1. Roth IRA contributions are not tax deductible
Roth IRAs are funded with contributions of after tax dollars, which is to say income which has already been taxed. Even if the government were to come up with a scheme to tax the income portion of withdrawals, the actual contributions will almost certainly remain tax free.
2. Roth IRAs were established to help build the nation’s capital base
While we might like to believe that the primary purpose of establishing tax sheltered retirement plans is mainly the government’s way of enabling us to prepare for our own retirements, there are other factors that operate at a much higher level. In general, every nation needs a capital base on which to build and expand its businesses and industries. That means somebody somewhere needs to be saving money that will eventually find its way into equity and debt offerings. In addition, large federal deficits mean there has to be capital in existence to purchase the governments debt. However, Americans are notorious for being non-savers—except in tax sheltered retirement plans! No matter what methods the government may attempt to raise tax revenue, retirement plans are likely to retain their favored tax status. Favorable tax treatment is the entire reason why anyone even invests in retirement plans; if it goes away, so do the plans—and the nation’s capital base. And that will lead to even bigger fiscal problems than we have now. Which leads us neatly into the next reason why Roth IRA withdrawals are unlikely to be taxed…
3. Taxing withdrawals will end the Roth IRA program
Making withdrawals from Roth IRA’s taxable will almost certainly end the program! Tax exempt withdrawals are the “magic bullet” that drives the plan. Take it away and you’re basically left with a non-deductible IRA—and we already have that. The Roth IRA program is growing rapidly, making ever larger contributions to the nation’s much needed capital base. We can rest assured the government has no interest in ending the program, which is exactly what will happen if withdrawals are made taxable.
4. Roth IRAs are small tax bases compared to other retirement plans
Roth IRA plans are a relative retirement plan light-hitter. Established in 1997, contributions are limited to $5,500 per year. Compare that to 401(k) plans, which have been around since 1974 and have contribution limits of $17,500 (plus employer matches!). If the government were looking for tax revenues, 401(k) plans have a much larger tax base.
5. Even if Roth IRAs are taxed someday, participation up to that point will likely be “grandfathered”
How can we know this for sure? Just read the tax code—it’s filled with special provisions. Look for the prefix “pre-”, followed by a date, or “post-”, followed by a date; they’re all over the IRS regulations. When ever they appear it usually means that a special allowance has been made for anyone who participated in a program before or after the laws or regulations were changed. This will almost certainly be the case if Roth IRA withdrawals are made taxable at some point in the future. So based on what we know today, continue funding your plan and do it with confidence. If you haven’t started saving with a Roth IRA yet, research and open an account today. You’ll thank yourself in retirement.
Photo by Phillip Ingham via Flickr