Are Roth IRAs a Time Bomb?

| Mon Apr. 11, 2011 11:06 AM EDT

Everybody loves Roth IRAs. I'm pretty sure Marian and I max out our Roth contributions every year, and why not? Withdrawals are 100% tax free. What's not to like?

Well, for one, the fact that withdrawals are 100% tax free. Down the road this means lots of savings income free of taxes and a significant loss of revenue for the federal government. That's why Gerald Scorse took to the pages of the LA Times this weekend to say that it's time to retire the Roth IRA. Megan McArdle thinks this is a harbinger:

I'm less excited about Roth IRAs than most people who write about personal finance, and that's because over the years, I expect we're going to see a lot more op-eds like Scorse's. When I look at the budget problems we face, I'm skeptical that Congress is going to live up to its promise to keep its hands off that money. At the very least, I'd bet that high earners are going to see some sort of surtax on their Roth withdrawals.

Of course, I think this is true of non-Roth retirement savings as well. Ultimately, Congress is going to be faced with penalizing people who didn't save adequately for retirement by cutting their benefits, or penalizing people who did save, by raising taxes on their savings. For a lot of reasons, I expect them to err on the side of penalizing savings. This may have some very ill effects on capital formation in the US — but by the time they're making this decision, everything they do is going to have some very ill effects on something.

For what it's worth, I think Roth IRA's are safe. Congress fiddles with ordinary tax rates all the time, and it's well understood that just because a particular rate stands at one level today is no guarantee that it won't be higher or lower in the future. But Roth IRAs are different: these come with an absolute promise that they won't be taxed, and I don't expect Congress to renege on that. I'm pretty sure they've never reneged on a similar promise in the past, and Roth IRAs are so widely held that the political backlash would be huge if they tried.

In any case, Scorse doesn't recommend this. All he says is that Congress should halt new contributions to Roth IRAs or, at a bare minimum, stop expanding the Roth IRA program. He doesn't suggest taxing withdrawals from existing IRAs.

As for retirement savings, I'm not sure why this is any kind of crisis, either now or in the future. Social Security is the main vehicle by which the federal government gets involved in retirements, and it's in good shape. It can remain in good shape forever with fairly minor tweaks to revenue and benefit levels, and I expect those tweaks to be made eventually. There's no reason Uncle Sam has to stick his hands into your Roth IRA in order to accomplish this.

As for the rest of our long-term deficit problem, who knows? The federal government is obviously going to have to raise more money in the future, but I'd be very surprised if higher taxes on savings vehicles were a major part of how this happens — and certainly not taxation of Roth withdrawals, which would break a clear promise and provide very little additional revenue. I'd guess instead that over time we're going to raise another 5-7% of GDP via higher taxes on ordinary income, elimination of some tax expenditures, higher rates on dividends and capital gains, and possibly even a VAT.

In the meantime, though, Scorse is probably right: Congress and the president should resist the temptation to expand Roth IRAs. As long as they're fairly smallish savings vehicles for middle class families, they aren't doing much harm and they're probably safe from congressional meddling. It's probably best to keep them that way.