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Roth IRA Phaseout Makes No Sense

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I can understand why certain things in our tax structure have phaseouts, like who is eligible for the earned income credit and who is permitted to take what deductions, but the phase out for the Roth IRA simply doesn’t make much sense.

The general purpose of a phaseout is so that only a select few are able to take advantage of something because they are perceived to need the help. In the case of the earned income credit, it’s designed to help those with low incomes and so it makes sense that you must earn under a certain amount to qualify. In the case of some deductions, such as the mortgage deduction if your home is less than $1M, it makes perfect sense because folks who own multi-million dollar homes don’t need an extra hand with homeownership. If they did, they would’ve bought a more modest home.

But it’s the Roth IRA… it’s sole purpose is to give you some tax diversification by allowing you to save $4k a year and have it grow tax free. The money is taxed before it enters the IRA, so the rich get do not get a bigger benefit (in fact, they pay more for the benefit of a Roth IRA because their marginal tax rate is higher). Is the government saying that the rich don’t need tax free growth? The Roth IRA is only a better choice over a Traditional IRA if your marginal tax rate is higher when you’re retired – when is that more likely, when you’re making a lot of money now or when you’re making a more modest amount now? I’d say the latter but those in the former group don’t have a choice in contributing (or is the government protecting the rich from themselves? conspiracy!)

So why do you think is the reason or reasons why the phase out exists?

{ 18 comments, please add your thoughts now! }

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18 Responses to “Roth IRA Phaseout Makes No Sense”

  1. Alex says:

    I tend to agree, but I think you have forgotten one thing. The rich could take capital gains (taxed at a favorable 15%) and use that to fund a Roth IRA. Then, they would be able to shelter that money from further capital gains taxes.

  2. Jeremy says:

    The reason is simple. They want to collect as much in taxes as possible. The more money you make the more likely you will be to take advantage of this tax free investment vehicle. So by phasing it out so that high incomes can’t participate they keep the number of people taking advantage of this down. They know that many modest income families won’t be maxing our their roth every year, yet someone with a lot of disposable income certainly would.

    And who says all of the tax breaks are for the rich…

  3. plonkee says:

    I don’t know very much about the Roth IRA but its a tax break, right? If you believe in some form of wealth redistribution then perhaps you don’t want to give it to the rich, but give it to the poor? Although I always had the impression that Yanks weren’t into wealth redistribution.

  4. Easy E says:

    The government is a bunch of morons and they never think before they act.

    VOTE RON PAUL!

  5. Dean in Des Moines says:

    Perhaps because if congress didn’t have to vote it back in they couldn’t get credit for it a second time. They get to look like heros repeatedly.

  6. broknowrchlatr says:

    The government doesn’t even know. They let anyone have an IRA. Anyone can have a 401k. If your employer gives you the ROTH 401k option, there are no income limits to that. They even let you roll a ROTH 401k to a ROTH IRA. You just can’t contribute directly to a ROTH. Its just a matter of old rules they don’t want to bother fixing.

  7. KMC says:

    Those poor rich people.

    I think what the law is intended to say is rich people don’t need yet another way to get tax-free money. Let’s face it – the wealthy have access to means of sheltering assets the rest of us don’t. Besides, every dollar that is not collected from the wealthy has to come from somewhere – you and me or our progeny.

  8. Ashley Barton says:

    I have a problem with the following statement that I see repeatedly when comparing a Roth and Traditional IRA:

    “The Roth IRA is only a better choice over a Traditional IRA if your marginal tax rate is higher when you’re retired”

    I think this statement comes from a simplistic view of each type of account. Take this scenario for instance, if two different individuals, both in the 25% tax bracket, both contribute $4000 to an IRA in the same year, the first person contributes to a traditional and the second contributes to a Roth. After X number of years, invested in the same type of investments, each account is at retirement is worth $12,000.

    When the first person takes this $12,000 from his traditional IRA at retirement, if he is in the 15% bracket, the taxes owed would be $1800, in the 10% bracket taxes would be $1200.

    The second individual only pays taxes on the original $4000 contribution at 25%, or $1000 in taxes, regardless of what tax bracket his is in at retirement, he will have paid less taxes by making the contribution to a Roth IRA versus a Traditional IRA.

    So you see your expected retirement tax bracket shouldn’t be the sole condition for determining whether you should contribute to a Roth or Traditional IRA.

    • Anon says:

      That is both confusing and still overly-simplistic. Oh, and also wrong.. (a) The investor in the Roth had to pay $1333 dollars in taxes, not $1000. (b) You did not account for the time value of that $1333.

      How about this explanation: The Roth IRA is a better choice if your marginal tax rate is higher when you’re retired.

  9. Phil says:

    Unfortunately, we here in the United States continue to be plagued with a draconian and woefully out-dated, multi-bracketed, >60,000 page income tax system. In fact, the only real reason to have an income tax system as we have now is to perpetuate class warfare.

    I would like to see a multi-year planned phase-out of the current system to where we first join the growing ranks of countries enjoying a low flat income tax structure, and then eventually replace the income tax with a consumption tax.

    Contemporary liberals should actually hate an income tax because it has always been the historical means by which the state conducts war with other countries.

    While this is obviously a bit of a soapbox for me, I don’t quite get why so many people are completely OK with allowing the government to know enough about everyone’s life to dictate retirement planning and anything else having to do with one’s income?

    -Phil

  10. pfodyssey says:

    I agree with Jeremy – it’s all about getting the taxes. The “rich” pay a bit more, the “less than rich” pay a bit less.

  11. Ashley Barton says:

    Since you believe my statement is wrong, feel free to explain how 25% of $4000 is $1333. Also, please elaborate on you point (b).

  12. Mary C. says:

    Because you would have to earn 5333 less taxes of 1333 to invest 4000 in a Roth.

  13. Mary C says:

    Because you would have to earn 5333 less taxes of 1333 to invest 4000 after tax (25% bracket). (Divide 4000/1-.25 to get this number).

  14. Mase says:

    Actually, the government is getting rid of the phaseouts in 2010. See this, for a quick article about it:

    http://personal.fidelity.com/myfidelity/email.html?http://myfidelity.members.fidelity.com/investorsWeekly/cms/FEA0701rothconvert.dyn;mfSessionId=VHGAVW4UUWSPSCQEFEPCFFI?keyword=retirement&sourcecd=FEA

    Thus, until 2010, if you want to have a Roth, but are unable to due to income limitations, open and fully fund a traditional IRA (without any tax deductions) and convert it to a Roth in 2010. Will have to pay tax on the earnings, but thats it.

  15. dong says:

    While I agree in general the phaseout doesn’t make sense, i think because the Roth IRA can be inherited tax free there is some reason to prevent the truly wealthy from passing on too much money to future generations complewtely free of taxes. This would’ve been particularly true if the estate tax were permanenatly eliminated. For that reason I can see some reason for the phaseout. Howevever, I would’ve addressed that the problem with the estate tax…..

  16. I don’t understand the phase out either. As you say, it seems more like a tax hedge than a tax break.

  17. snrub says:

    The thing I don’t understand is why have both a contribution limit and an income limit. If you want to make sure “rich” people can’t have a tax shelter then fine, even though I think that is stupid, but if you’re going to limit which people can contribute, then why not remove the contribution limit. Better yet, let everybody contribute their $4000.


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