Will Congress Make Your Roth IRA Taxable?

From Bob Jennings at TaxSpeaker. Check out TaxSpeaker at taxspeaker.com

The title of this post will develop an earthquake of worry in the stable ground of retirement planning. The answer is unknown of course, but precedent does exist for making Roth accounts fully or partially taxable by looking at what Congress did with Social Security.

A Synopsis of the Taxation of Social Security Benefits 

When the Social Security system began over eighty years ago, the receipt of Social Security benefits was specifically excluded from taxable income. This was an unusual Treasury ruling because at that time (and still today) conventional retirement plans made the portion of benefits attributable to earnings and employer contributions taxable, while exempting employee contributions. 

This tradition continued for over 40 years until the early 1980’s when the Social Security system began facing some financial issues. Congress established the Greenspan Commission to study the issue, and they proposed making the roughly 50% portion of Social Security taxes paid by the employer taxable to the employee at withdrawal starting in 1983. The income threshold of taxable benefits resulted in the Commission estimating that its proposals would affect only about 10% of Social Security beneficiaries and that it would result in $30 billion in revenue to the Trust Funds in the first seven years.

About ten years later Congress decided to also go after the equivalent earnings that were sheltered inside of Social Security. Remember, Social Security is made up of three parts (primarily): worker taxes; employer taxes; and earnings on both amounts. In 1993, as part of the Omnibus Budget Reconciliation Act, the Social Security taxation provision was modified to add a secondary set of thresholds and a higher taxable percentage for beneficiaries who exceeded the secondary thresholds.

The changes introduced by the 1993 amendments were designed to make the treatment of Social Security benefits more closely approximate to private pensions. To this end, the taxable percentage was set at 85% for higher-income beneficiaries. New thresholds were added, but only to differentiate those subject to the higher percentage from those still subject to the 50% figure. Inflation has left those thresholds in the dust of political promises.

So within a ten year span, America had gone from no tax on any portion of the three elements of Social Security benefits, to taxation of two of the three pieces: the equivalent employer contribution becoming taxable in 1983 and the equivalent earnings becoming taxable in 1993.

The Roth IRA 

In contrast to the Social Security system, the Roth IRA is only made up of two components: non-deductible worker contributions and earnings. Established by Congress in 1997, the Roth IRA has historically offered both tax-free accumulation of earnings as well as tax-free distributions at retirement if a few simple tests were met.

Precedent exists for making Roth IRA earnings taxable as we see in the previous discussion on Social Security. Congress has even looked into prohibiting Roth IRAs in certain instances when an individual has accumulated “too much”, as well as prohibiting ROTH conversions. (See 2013’s proposed RISA Act as sponsored by Senator Wyden).

Some experts have extrapolated the Federal Reserve’s Board of Governor’s report to estimate national Roth balances by the end of 2025 to be as much as $11 trillion dollars. If 50% of that amount represents earnings currently accumulated in a never-to-be-taxed again account, that would be over $5 trillion dollars, and the Investment Company Institute has estimated that only about 25% of these balances actually represent contributions. A more realistic estimate then, is that somewhere around $8.5 trillion dollars represents earnings currently held inside Roth IRAs.

The current US federal debt is over $38 trillion according to the US Treasury, with a projected 2025/2026 Federal deficit will be about $1.8 trillion according to the Congressional Budget Office.

Summary 

Precedent exists at the Federal level for changing the taxability of previously exempt items, as we saw with Social Security. Politically, taxing people who accumulated “more than Congress designed” in plans must consider that the taxability of their accumulations may change very soon. In contrast to most retirement experts recommending Roth conversions, maximum contributions, Mega Roths and more, I am strongly recommending a reconsideration of the idea as a word of caution.