If you want to an evening of contemplative reading google the phrase traditional vs roth ira. It seems that every financial institution has information to help investors make the decision on which type of IRA to use. For those who already have a Traditional IRA there are countless calculators that can help you determine whether you should convert your current IRA to a Roth IRA. They ask for information such as current tax rate, future tax rate, time till withdrawal and a few other pieces of information to help you make your decision.
These calculations will provide you with dollar and cents answers but the one factor I rarely see people consider is how changing tax laws could impact a Roth IRA. The real tax benefit of a Roth IRA is received at some future date. Yes, your dollars are allowed to grow without paying taxes every year for realized gains and income but the greatest benefit (and the differentiating factor from the Traditional IRA) is that no taxes are owed when the money is withdrawn at a future date. If you are in your 30’s or 40’s that future date could be between 15-35 years away. That’s a long time for things to change. What could change? Let’s look at one example:
At the time I am writing this (March 2015) at least one of the remaining Republican candidates for the Presidency has proposed a tax plan that includes a 15% flat income tax and the implementation of a Value Added Tax (VAT). As Americans, most of us are not familiar with the VAT tax system. It was widely implemented in Europe in the 1960’s and is in place in a large portion of the world’s developed economies. To keep the explanation short it is a tax on goods purchased. That may sound like a sales tax but the tax isn’t levied at the point of sale. It is levied at each level of production of the good. The bottom line…the tax gets baked into the price of the good you are purchasing, which makes that good more expensive to buy.
Bringing this back around to the Roth IRA…if a VAT tax were to get implemented the money you invested in a Roth IRA so you wouldn’t have to pay taxes on withdrawals are now being taxed through increased price of goods. In this instance the tax benefit of a Roth IRA is reduced.
This is example of what could happen. I am not saying it will but it could. And there are other possibilities of things that could happen. A lot of strong proponents of Roth IRA’s use the argument that tax rates are going up (sometimes with the supporting point that taxes only go up, never down…go look at historical tax rates in the US and let me know how well that argument stands). If taxes are going up because the government needs more revenue than how do we know those taxes won’t get levied against Roth IRA’s? Don’t think the government will do that? Once again, look to history to see what our government will or won’t do when it comes to tax law…I think you will be surprised.
Is this to say Roth IRA’s are bad and should never be used? No. But the question I would encourage you to consider is why would you give up a tax benefit you can get today (deduction for a Traditional IRA contribution) in exchange for one you might get in the future (tax free withdrawals from a Roth IRA)? The tax savings you receive from Traditional IRA contributions are real dollars. Dollars that can be used elsewhere…reducing a mortgage balance, saving for college, etc. Is the promise of a future benefit worth giving those dollars up? It is a question worth considering.