Rehabilitating Frankenstein's monster: Repairing the public policy of the roth IRA.

• Author: Kofsky, Ausher M.B.

"Did I request thee, Maker, from my clay To mould me man? Did I solicit thee From darkness to promote me?" (1)

INTRODUCTION

A 2011 Los Angeles Times op-ed warned that Roth Individual Retirement Accounts ("Roth IRAs") are a dangerous "fiscal Frankenstein." (2) The author declared: "[T]here's little doubt that Roths are wrong for America. They're Frankensteins, fated to wreak havoc. It's time to retire Roth IRAs." (3) Likewise, since the federal government enacted the Roth IRA in 1997, (4) other detractors have sharply criticized the accounts. Even early on, one skeptic called the Roth IRA the "ultimate budget gimmick." (5)

Are the condemnations correct? Before answering that question, which is the heart of this article, the following is a quick explanation of the Roth IRA. The Roth IRA is simply a personal retirement savings account where the owner prepays the tax. (6)

Operationally, the Roth IRA functions as the mirror image of its older sibling, the traditional IRA, which Congress created in 1974. (7) The timing of the income tax liability is the main difference between the two types of retirement accounts. (8) As noted, Roth IRA owners owe income tax for the initial year of contribution or conversion. (9) The principal and earnings are then forevermore income tax free. (10) Because of that timing--owing the tax upfront--the nomenclature calls the Roth IRA an "after-tax account." (11) Traditional IRA owners, on the other hand, generally receive a deduction in the initial year for contributions. (12) They then owe income tax on the principal and earnings only later in their retirement years when they take distributions. (13) Consequently, the vernacular identifies the traditional IRA as a "pre-tax investment" because the growth occurs before the taxpayer owes the tax. (14)

As far as proportion, Roth IRAs are a relatively small slice of the retirement pie. At the end of 2015, Americans owned $24 trillion in retirement assets. (15) Of that amount, Roth IRAs totaled $660 billion, or a little under three percent of the total. (16)

Notwithstanding its comparatively small size, good reasons exist to examine the Roth IRA. One reason is the criticisms noted above. Are Roth IRAs really a fiendish federal fiscal fraud? Another reason is that two-thirds of a trillion dollars is not a trivial number. Additionally, during the past decade, the rate of growth in Roth IRAs has been nearly three times faster than the growth of traditional IRAs. (17)

Further, many financial commentators in the popular press have praised the Roth IRA. For example, in 2014, a writer from Kiplinger's Personal Finance magazine concluded that nearly all individuals, regardless of their age, could benefit from the Roth bargain: paying a little tax now in return for a larger tax-free account in the future. (18) Even early on, a 1998 article in Forbes thanked Congress for the Roth IRA for serving as a terrific estate planning tool. (19) Moreover, Presidents Clinton, Bush, and Obama have each signed off on legislation enacting or expanding Roth IRA eligibility. (20)

Consequently, the goal of this article is to determine whether the critics or the advocates are correct with respect to the wisdom of the Roth IRA as a public policy. The article determines that in many ways, the Roth IRA is indeed akin to the Frankenstein trope, but not in the purely negative cliche the creature has come to symbolize. Dr. Frankenstein had originally created his creature with positive virtues. (21) Dr. Frankenstein, however, immediately abandoned his creation (22) because the creature, in response to rejection by other humans, did act monstrously. (23) The article therefore concludes that the government should not abandon the Roth IRA, but instead, Congress should enact sensible restrictions to minimize the harmful effects.

Section I explains the main differences between a traditional IRA and a Roth IRA. Section II provides the historical background to current U.S. retirement policy. Section III describes the need for personal retirement savings. Section IV details the legislative development and expansion of the Roth IRA. Section V analyzes the criticisms of the Roth IRA. Section VI offers recommendations to Congress. In the end, the article's goal is to offer recommendations by which the Roth IRA monster can become a benevolent humanitarian.

1. THE DIFFERENCES BETWEEN A TRADITIONAL IRA AND A ROTH IRA

   The Roth IRA is simply an after-tax approach to retirement savings that is opposite in tax payment timing from the previously enacted pre-tax traditional IRA. (24) Below are examples illustrating the difference in the methodologies between the traditional IRA and the Roth IRA.

   1. The Traditional IRA

      Contributions to a traditional IRA usually reduce the taxpayer's gross income. (25) For example, suppose a taxpayer age thirty-six received a salary of $95,000 in the current year. If the taxpayer made a $5,000 contribution to a traditional IRA, the taxpayer would owe federal income tax on the reduced income figure of $90,000. Assuming a thirty-five percent combined federal and state marginal income tax rate, the taxpayer would have saved $1,750 in income tax for that initial year.

      Now suppose thirty years goes by at which time the taxpayer, now age sixty-six, retires and takes a full distribution. Assume the $5,000 had grown to $50,000 from dividends, interest, and appreciation. The taxpayer would have owed no tax on the growth and earnings during the thirty year interim period. (26) The taxpayer, however, would have to include the entire $50,000 in gross income for the year of distribution. (27) If after inclusion the taxpayer had a combined federal and state marginal income tax rate of twenty-five percent, the taxpayer would owe income tax of $12,500 on the distribution. Therefore, to summarize the traditional IRA arrangement, the taxpayer would have saved $1,750 in income tax upfront but thirty years later would have owed income tax of $12,500 on the distribution.

   2. The Roth IRA

      As noted, the Roth IRA functions in the reverse manner of a traditional IRA. To begin, this section uses figures similar to the above traditional IRA example. Assume a taxpayer age thirty-six with a $95,000 salary makes a $5,000 contribution to a Roth IRA. Initially, for that first year, the taxpayer would be relatively worse off with a Roth IRA because he or she would owe federal income tax on the entire unreduced $95,000 of gross income. That is because Roth IRA owners do not receive a tax deduction for their contribution. (28) Therefore, a taxpayer in the thirty-five percent combined federal and state income tax bracket would have an opportunity loss of $1,750 by forgoing the $5,000 income tax deduction.

      Conversions to a Roth IRA work in a similar manner. Suppose the above taxpayer had taxable income of $90,000 and from a previous year already owned an existing traditional IRA with a balance of $5,000. If that taxpayer were to convert that $5,000 traditional IRA to a Roth IRA, the taxpayer would have to include the conversion amount in gross income. (29) In this example, that would result in a total gross income of $95,000 for the year of conversion. In other words, the taxpayer would owe income tax on the $5,000 at the above hypothetical combined marginal income tax rate of thirty-five percent, or $1,750.

      For both cases--the Roth IRA contribution and the Roth IRA conversion--assume that thirty years later the $5,000 Roth IRA account had again grown to the same amount as above, $50,000. As before, the taxpayer would have owed no tax during the thirty years of growth and appreciation. (30) Continuing, assume that this taxpayer likewise retired and took a distribution of the entire $50,000. Different from the traditional IRA, the Roth IRA owner would owe no income tax on the distribution because the Internal Revenue Code excludes the entire Roth distribution, here $50,000, from the taxpayer's gross income. (31) If, as before, the taxpayer were in a twenty-five percent income tax bracket in the year of retirement, the taxpayer would have, but not owe, the $12,500 income tax on the $50,000 distribution. Thus, opposite to the traditional IRA, the Roth IRA owner effectively or actually paid $1,750 upfront for a tax savings thirty years later of $12,500.

   3. Other Significant Differences between a Traditional IRA and a Roth IRA

      A major impact of the above timing difference is that Roth IRAs generate immediate tax receipts for the federal government and for state governments that piggyback on federal inclusion. (32) Conversely, traditional IRAs delay government tax receipts until the ultimate distribution date. (33)

      Traditional IRAs and Roth IRAs have other significant differences. One of the main ones involves the mandatory distribution rules. (34) To prevent traditional IRA owners from receiving an unending income tax deferral, Congress requires owners of traditional IRA accounts to start taking compulsory distributions beginning no later than April 1st following the calendar year in which the owner turns age seventy and one-half. (35)

      Congress did not apply the mandatory required distribution rules to owners of Roth IRAs because, as noted above, the owners have already paid the income tax upfront. (36) In other words, Roth IRA owners have no required distribution date because the government has no future income tax to collect. (37) Consequently, the Roth IRA tax-free distributions may occur twenty, forty, or any number of years in the taxpayer's future. (38) Further, unlike traditional IRAs, individuals may contribute to a Roth IRA after age seventy and one-half. (39) Thus, Roth IRAs provide an alternative for individuals to choose the best way to structure their future finances.

      Moreover, the Roth IRA tax-free growth can continue beyond the taxpayer's lifetime. (40) Roth IRA owners, as can traditional IRA owners, can transfer their accounts via bequest to their children or, through...