How Much Do You Trust the Government?

It’s hard not to love the Roth IRA because once money gets into the account, all withdrawals should stay tax-free forever.

That’s in contrast to a traditional IRA, which incentivizes savings by offering a tax deduction at the time of the contribution and allows the assets to grow without taxation. The downside is that withdrawals are taxed as ordinary income.

We call those tax-deferred accounts because you put off the taxes, but they don’t get eliminated. In theory, your tax bracket is lower in retirement than it was while working, so that can be a real benefit if your deduction is at the 35 percent bracket and the withdrawals are made at the 22 percent bracket.

The Roth IRA is much newer than the traditional IRA. The Roth was introduced in 1997, whereas the traditional IRA dates back to 1974.

While you don’t get an upfront deduction, the assets in a Roth grow tax-free, and the withdrawals are tax-free.

Who doesn’t love tax-free forever? Why not go all-in on the Roth?

Well, the big risk to Roth IRAs is that the government changes the rules and taxes even though the government says it won’t.

If that seems overly cynical, recall that Social Security wasn’t supposed to be taxed either. In fairness, the government held off on taxing it for almost 50 years, from 1935 to 1984.

Right now, the government loves Roth IRAs because many investors (myself included) are willing to pay higher taxes today than necessary in hopes of lower tax bills in the future.

But, the government is short-sided. I’m sure there are very bright economists somewhere who look at the long run, but lawmakers focus on the next ten years. As long as the problem is in year 11, it’s no problem.

That has already worked for a long time and will no doubt continue to work for some time, but it will eventually stop working. At that point, lawmakers may look at all of those tax-free Roth assets and decide it’s unfair that people get these tax breaks and change the rules.

I don’t think this is likely anytime soon, so I still use Roth accounts for myself and recommend them to clients. Ultimately, I think the best strategy is to diversify across taxable accounts (individual, joint, trust, etc.), tax-deferred (IRA, etc.), and tax-free accounts.

Having a diverse mix of assets by account type should allow the most flexibility regardless of what tax regime you encounter in the future. Putting everything into a Roth is putting too much faith in today’s rules, which are subject to change.