Friday, December 12, 2014

Some Roth is Good; “More” May Not Be

One of the “grand old men” of the U.S. Senate in the modern era was William Roth, the late lawmaker from Delaware.  Senator Roth championed tax-advantaged retirement savings options to assist American workers in preparing for a secure retirement.  The Roth IRA, provisions for which were enacted in 1997 and became effective in 1998, was named for him as a tribute to this legacy. 
The chief characteristic that distinguishes the Roth IRA from the familiar Traditional IRA is the absence of a current-year tax deduction, while offering the potential for tax-free earnings in the future.  This benefit is earned after a five-year period, and when the taxpayer satisfies one of several other qualifying conditions, which include reaching age 59 ½, making a first home purchase, becoming disabled, or upon death.  Fast-forward to today, and we see an expansion of this concept to include “designated Roth contributions” in 401(k), 403(b) and governmental 457(b) plans.  This option allows the deferral contributions withheld from employees’ paychecks to be treated in the same way as Roth IRA contributions.  There is no current-year benefit in the form of an exclusion from taxable income, but there is similar potential for tax-free earnings after five years.  “Tax-free” earnings is a benefit available almost nowhere else.

In addition, not only can contributions of a Roth nature be made, but existing pre-tax balances in Traditional IRAs and employer-sponsored retirement plans can be remade and given Roth status by a process called “conversion,” or “in-plan Roth rollover” in the case of employer plans.  When that happens – when these pre-tax assets are converted to after-tax amounts – tax revenues are generated, but the new Roth assets begin generating earnings that could eventually be tax-free.
The driving force behind the Roth concept in IRAs and deferral-type employer plans was not some Santa Clause-like generosity on the part of senators and congressmen.  The motivation was the effect that these contributions had – or didn’t have, to be more accurate – on the federal budget process.  Congress typically tallies up or “scores” the tax consequences of a bill within a five or 10-year time horizon, or “window.”  Tax deductions or tax exclusions result in an on-paper loss of federal tax revenue, and can complicate budgeting.   But when retirement saving is done on an after-tax basis like the Roth concept represents, immediate tax revenues appear undiminished, and can be assigned by Congress to other uses. 

Magnifying this effect, the conversion of pre-tax IRA or employer plan amounts to Roth status actually generates new tax revenue in the year the transaction occurs.  This has been used as a tax-generating device by Congress on more than one occasion.  The Tax Increase Prevention and Reconciliation Act (TIPRA) was signed into law in 2006.  In order to generate more tax revenue Congress opened wide the door to conversions, eliminating – beginning in 2010 – the $100,000 taxpayer income ceiling for Roth IRA conversion eligibility.  Furthermore, Congress offered an attractive incentive to complete a conversion.  The taxation of conversions executed in 2010 could be split equally in 2011 and 2012, the objective being to drive additional tax revenue into those years to offset other budget items. 
The Roth concept also figures heavily in proposals for future tax reforms.  Outgoing House Ways and Means Committee Chairman Dave Camp has laid out the most comprehensive tax reform proposal to date, one of whose stated purpose is to reduce individual and corporate tax rates.  To “pay for” these reduced tax rates, many existing tax deductions and exclusions could be reduced, or eliminated.  For example, Camp recommends eliminating the tax deduction and all future contributions to Traditional IRAs, and allowing all taxpayers – even those of highest incomes – to make Roth IRA contributions instead.  Rep. Camp also proposes allowing Roth-style contributions to SIMPLE IRAs, and requiring large employers sponsoring 401(k)-type plans to limit pre-tax deferrals to half the statutory limit. 

The goal of this proposal is to drive more saving into Roth arrangements, and thereby greatly limit taxpayer deductions or exclusions from current-year taxation.  The upside for taxpayers, and there certainly is one, is potential tax-free earnings in the future – after meeting the previously-described conditions for qualified distributions. The downside for the federal budget is a significant reduction in future tax revenues.  While tax reduction is a definite public good in many ways, there are certain national needs for generating tax revenue, well beyond various entitlements that may – or may not – be prudent spending.  National defense, Social Security, transportation infrastructure, science and technology, education and certain other expenditures, may be necessary to keep our nation strong and competitive.  These, by their nature, are funded through taxes, whether we like it or not.  Eliminating or reducing a significant source of these future revenues is concerning and may be a case of "kicking the can" down the road and leaving it for someone else to solve potential future shortfalls. 
Some Roth in the mix of retirement savings options is definitely a good thing.  But it’s also important for lawmakers to be forward-thinking enough to consider future needs for fair and necessary taxation, rather than focus only on short-term solutions to our federal budget dilemma.