The Roth Rollover Boondoggle

By :: September 3rd, 2009

High-income investors are about to enjoy a massive tax windfall from Uncle Sam. In just a few months, they’ll be able to convert their Individual Retirement Accounts--where investment earnings are taxable at withdrawal-- to Roth IRAs-- where they are tax-free. As financial planners are happily telling their big-ticket clients, this will be the gift that keeps on giving.

You’d think that, facing a deficit of more than $1.5 trillion this year and more than $9 trillion over the next decade, President Obama would be thinking twice about this. But, as far as I can tell, he is not. So if you are making more than $100,000-a-year and have an IRA, get ready to roll on January 1.

Not only can you convert existing IRAs, but you’ll be able to make new contributions to a Roth, now barred for those making $100,000 or more. You’ll first have to contribute to a non-deductible IRA, then roll to a Roth, but given the tax savings involved, it is worth the paperwork. Another nice deal: Unlike a traditional IRA, you won’t need to make withdrawals at 70 ½ (or ever). Thus, rich retirees who don’t need Roth assets to pay the pool boy can keep accumulating tax-free assets until they die. Finally, if you think tax rates will rise (not a bad wager given the ballooning national debt), you can lock in today’s relatively low rates by converting.

The rollover works best for those who are sufficiently wealthy to pay the tax out of their taxable accounts, rather than having to dip into the IRA itself. Their only downside to the converted: some of the tax benefit will disappear for those hit by the Alternative Minimum Tax.

The scandal is that this give-away was adopted as a revenue raising measure. Under Congress’ bizarre budget rules, it helped “pay for” President Bush’s 2005 proposal to extend low rates on capital gains and dividends through 2010 and provide additional temporary relief from the Alternative Minimum Tax. So, Congress financed a set of unaffordable tax breaks with another unaffordable tax break. Only in Washington.

Here’s how: When you convert to a Roth, you’ll be taxed as if the transaction were an ordinary distribution, though you get to pay over two years. The Joint Tax Committee figured it would generate about $6.5 billion over the 10 year budget window (which is all Washington cares about). But the long-run story is dramatically different.

TPC’s Jeff Rohaly estimated the long-term revenue loss at an eye-popping $100 billion by mid-century. The net present value of the break, which matters since investors are paying tax upfront and will get their tax benefits over many years, will be almost $15 billion. For the government, that’s more than $2 lost for every dollar gained. Indeed, Treasury will lose more and more money each year until 2046, when many of those enjoying the windfall will have died off. Worst of all, the greatest drain on the Treasury will occur just when the aging Baby Boomers are putting the most pressure on the federal budget.

It will be fascinating to see how the rollover works in the current economy. Two thoughts come to mind. First, because stock prices are lower today than JCT thought they’d be, Treasury may end up with much less money inside the budget window than Congress expected. Second, I wonder if some of those taking advantage of the windfall will end up spending less so they can pay the rollover tax, thus slowing the economic recovery.  Oops.   

Whatever happens in the short-run, the Roth rollover is a deal with the fiscal devil. But  nobody is likely to do anything about it—at least not for a while.