Requiem for the Roth IRA

One of the great senators of the modern era was William Roth, by whose vision and persistence the Roth IRA was established in 1997, giving average Americans, especially those without a pension, the opportunity to build their financial independence without fear of rising tax rates.  

The Roth could be funded either with after-tax dollars or by converting money from a conventional IRA.  The original law said that: (1) the taxpayer could invest in a wider range of investments than with other tax-advantaged plans, (2) both the growth of and withdrawal from the account would be tax-free and (3) upon death, the account could pass to non-spousal beneficiaries who could let the funds grow tax-free during their lifetime.  The Roth was a superb financial planning vehicle for people with some assets, but who could not afford the elaborate trusts of the super-rich.

I quickly saw the advantages of the Roth, and gradually started converting my pre-tax IRA accounts in 2004.  For every dollar converted, I had to report it as income on my tax return and pay tax at my highest marginal rate.  Eventually, I converted all of my pre-tax IRAs to Roths, having paid huge amounts in taxes in order to fulfill my part of the deal that the government offered with the 1997 law.

Then in 2019, Congress changed the law by enacting the deceptively titled SECURE Act, which actually stands for “Screw Every Citizen Using Roth Equity.”  It reduces the lifetime growth of inherited Roths for non-spouse beneficiaries to only ten years, short-circuiting the compounding that was the intent of the original law.  This was the first step in devaluing the Roth. The SECURE Act passed without any objections by people who should have known better.

But SECURE was just a prelude to what is now being proposed as part of the duplicitously named “Build Back Better” Act.  There are at least seven major changes that seriously affect Roth (as well as pre-tax IRA) savers, but for brevity, we will discuss three which are likely to affect more people:

  • Prohibits the use of Roth funds for investments that require accredited investor status;
  • Prohibits the use of Roth funds for investments where the Roth owner has more than a 10% interest (vs. 50%) in the investment or where the Roth owner is an officer;
  • Both of these types of investments that exist in Roth’s at the time of enactment would be required to be divested from the Roth by December 31, 2023.

One of the advantages of the original Roth law is that it allows accredited investors to invest in private companies, real estate, and funds that provide early-stage companies with needed capital.  There are over 15 million households in the U.S. that meet the definition of accredited investor, whose freedom to invest as they choose will be taken away. 

The first change forces Roth investors to concentrate all of their retirement assets in the public stock market, rather than diversifying their assets as they see fit.  Ironically, the people who have proposed this change are the same people who vehemently argued against partially privatizing social security because they didn’t want people’s retirement savings to be invested in the “risky” public stock market.  But they have no problem coercing investors into putting all of their retirement assets in that same “risky” market.  This is another step in devaluing the Roth.

Let me give you a personal example of how this will affect investors.  Several years ago, I invested in an Angel fund that provides startup companies with capital, using Roth money for this investment.  I also invested in one of the companies in the fund, using Roth money.  It’s a great little company with a wonderful life-saving product.  These investments have increased the diversity of my retirement assets which I would not have been able to do if I was prohibited from tapping my Roth.  

The second change prohibits most founders and all officers from using Roth money.  Why should that be the case?  Roth money has already been taxed once.  The original law said, pay the tax upfront, and you can keep whatever gain you earn from your investment.  Founders and officers of startup companies, who are taking great risks to begin with, should be allowed the freedom to use whatever funds they possess for their investment. Now, because one notable person (Peter Thiel) has “won” the Roth lottery, Congress is using that as an excuse to control outcomes by taking away every investor’s choices. 

The third change is the most serious because it retroactively penalizes investors who have made a legal, permissible investment with their after-tax Roth dollars.  Investments in private companies or funds, by their very nature, do not have a marketplace of buyers and sellers and oftentimes are long-term investments.  To arbitrarily require divesting all such assets within two years guarantees that the investor will (1) incur a loss and (2) lose the opportunity to make whatever profit they would have made if the government hadn’t interfered with their commerce.  I am frankly astonished at the audacity of this provision.  Who are these people?  Where did they get these ideas? Do they really have the power to strip us of our property rights?  Is this constitutional?  Personally, I stand to lose about 20% of my retirement money if this proposal passes.  

Their ultimate goal is to devalue the worth of existing Roth dollars and to drive a stake through the heart of the Roth investment vehicle. Not content with having obtained tax revenue up-front, they just can’t stand the idea that the Roth allows people to make a profit without having it taxed again.  These proposals, if they become law, will be followed by another round, in which we will see the entire Roth framework destroyed.

Ask yourself why no one in the “erudite” financial press is up in arms about these proposals.  You will only find a few obscure articles using curiously identical language to minimize and mischaracterize their harmful effect.  This is the same kid-glove treatment that accompanied the SECURE Act prior to its passage.   There are no major players to defend the Roth.  The insurers, the brokerage firms, and the banks could not care less. The Republicans are their usual timid selves, and the Democrats are tenaciously focused on removing yet another of our freedoms.

Not allowing Roth money for private investments will have serious consequences on investors and small businesses by restricting an investor’s right to diversify retirement funds and invest in small businesses, start-up companies, and real estate, as well as support their own community at the same time.

Image: Investment Zen

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