Risky Roth IRAs

Comparing the risks of Roth IRAs versus traditional IRAs means weighing a future unknown benefit against a certain one. Traditional IRAs have immediate tax savings. Roth IRAs, on which taxes are prepaid, may have a future benefit that is less than the prepaid tax.

Specifically, there are three risk factors for Roth IRAs.

The first risk is the possibility that the IRS or federal income taxes may not exist in the future. Although you may be smiling (or, perhaps, even laughing), bear in mind that in June the House passed the Tax Code Termination Act, which would eliminate the current tax code (except for Social Security payroll taxes) on December 31, 2002.

In addition, a grass-roots group of taxpayers called the Citizens for an Alternative Tax System (CATS) is pushing for the Schaefer/Tauzin National Retail Sales Tax Act. This act would replace income tax with a sales tax.

The second risk is the possibility that money received from a Roth IRA distribution might not be subject to tax at all if, when it is combined with other earnings, the total amount of income has not reached a taxable level.

The third risk is the likelihood that the present value of the prepaid tax (the cost) of a Roth IRA may be greater than the present value of the future tax savings (the benefit).

For example, if a 40-year-old invests $2,000 yearly in a Roth IRA for 25 years (assuming a 28% tax bracket), the prepaid tax of $560 per year has a present value of $5,083. Assuming a 10% growth rate, the fund will grow to $146,694 in 25 years.

Still assuming a 28% tax rate, the tax savings with a Roth IRA (if all funds are withdrawn in one lump sum) will equal the $146,694 times 28% to a total savings of $41,074. The present value of $41,074 discounted for 25 years at 10% is $3,791. The net present value of a Roth IRA in this case would be a negative $1,292 ($5,083 cost minus $3,791 savings).

Observation. Clients should know that, unlike a traditional IRA that provides a certain immediate benefit, the benefit of a Roth IRA might be zero. The greatest risk of a Roth IRA, however, is that the present value of the prepaid tax could be greater than the present value of the future tax savings.

—W. Terry Dancer, PhD, associate
professor of accounting, Glen Jones,
JD, assistant professor of law, and
James Washam, PhD, assistant
professor of finance, Arkansas
State University.