Have you ever considered what happens to the "tax free" bene

[Guest BJames]

After considerable analysis, my wife and I decided that conversion of a sizable portion of our IRA holdings to a Roth IRA made sense -- the thought of tax free distributions seemed to dance through our heads. Around the time of our conversion, however, I started doing some reading, and having conversations with others, about the various alternative "income tax" systems (e.g., flat tax, national sales tax, VAT, etc.) being considered as a replacement to our current mess.

Without getting into all of the pros and cons of each alternative, let me say that the National Sales Tax (NST)intrigued me because as a tax on consumption, instead of income, it should go a long way toward capturing the current lost taxes on unreported legal, and illegal, activity. I believe that this unreported activity is easily 25% - 33% of what is reported today, and therefore if "collected" would lower the tax burden for the rest of us who pay taxes on everything we earn (assuming overall tax revenues collected remain the same).

The problem with this NST is that my dollars being distributed from a "tax free" Roth IRA look and spend just like any other dollars, and as such will be taxed via the NST when I go out to buy a car, or a shirt, or a Coke. I have not heard or read of anyone to date raising the issue that I have raised here, and I would like comments or ideas as to how you might see this being handled (perhaps someone is aware of something in the Roth legislation that covers this possibility). I'm not trying to be cynical here, and I don't give a very high probability to a NST replacing the current income tax, but I certainly don't want to find myself contributing to the "tax bag" with my Roth distributions.

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[John Olsen]

I believe you've identified the problem quite accurately. If a National Sales Tax is implemented, ROTH accountholders will lose the benefits promised.

Now, will that happen?

Nobody knows.

What are the CHANCES of that happening?

Nobody knows.

Personally, I cannot plan on that basis. Just as I cannot do estate planning on the basis that the Federal Estate Tax MIGHT be repealed.

So... I've taken the position that it's more an EMOTIONAL than FINANCIAL decision. As the financial consequences of your scenario cannot be quantified (unless one is willing to estimate the probability to the passage of a NST for the period of time being analyzed, and place sufficient faith in the result of any equation based on that estimate as to let it determine one's financial future), I think it's a matter of Sleeping Soundly.

If worry over the prospect of paying tax on the same dollars twice (which is what would happen if you converted to a ROTH and those ROTH dollars were then subject to a NST) will keep you awake at night, DON'T DO THE ROTH!

But I suppose I should confess, at this point, a rather strong bias. I believe that Financial Planning (and Estate Planning, too) is 90% emotional and 10% financial.

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John L. Olsen, CLU, ChFC

Olsen Financial Group

St. Louis, MO

[Guest BJames]

John,

Thanks for your response. I did convert some of our IRAs to a Roth (basically, as much as we could afford to pay the tax on without crimping our lifestyle too much), and I do sleep well. Since one is never sure who reads these boards, my motive for raising the issue is to get people (perhaps even someone in a position to do something about it) to think about potential solutions to the NST on Roth proceeds problems.

For example, I would assume that if an NST were to be implemented, there would still be some sort of means testing that would allow low income people to receive a "refund" on the NST they paid (probably some sort of sliding-scale fixed refund based on their income for the year, instead of making people save receipts from all their purchases to prove how much NST they paid). Therefore, it seems to me that a similar "refund" program could be established based on the annual distributiuon from an individual's Roth, allowing him/her to recoup the double taxation paid via the NST (now there's a novel idea -- eliminating double taxation!).

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[Guest haydenks]

What makes you think your Roth IRA benefit will be "tax free" anyway?

True, it will not be taxed directly when it is distributed, but what will you do with these funds once you receive them? You will use them to purchase goods & services - currently taxable - and/or additional savings - the interest of which is currently taxable.

You will have paid taxes on the original deposits and will pay additonal taxes in the form of consumption taxes!

[Guest haydenks]

What makes you think your Roth IRA benefit will be "tax free" anyway?

True, it will not be taxed directly when it is distributed, but what will you do with these funds once you receive them? You will use them to purchase goods & services - currently taxable - and/or additional savings - the interest of which is currently taxable.

You will have paid taxes on the original deposits and will pay additonal taxes in the form of consumption taxes!

[John Olsen]

Haydenks:

True, but a National Sales Tax would be IN ADDITION to State and Local sales taxes. Thus, the money WOULD be "taxed twice", compared to the tax treatment under the present setup.

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John L. Olsen, CLU, ChFC

Olsen Financial Group

St. Louis, MO

[Bruce Steiner]

If you are age 65 and convert to a Roth IRA, and you live another 20 years, and you then leave it to or in trust for the benefit of a grandchild age 20, with a 61.9 year life expectancy, it will be about 82 years until all of the assets of the IRA are distributed. The income tax law has changed many times since it began in 1913, and it will likely change many more times over the next 82 years. The rates were as high as 91% as recently as 1964, and as low as 28% as recently as 1990. No doubt over the next 82 years there will be years when the rates are higher and years when the rates are lower.

The difficulty of a VAT is that, even if you give a credit to the lowest income people, it is hard to raise sufficient revenue from the highest income people.

Of course, in most countries, they have a VAT in addition to an income tax at rates higher than ours (and things such as medical care are paid for out of tax revenue).

Since no one can predict the future of the tax law over a long period of time, I suggest that people take advantage of the opportunities based upon the current tax law and what they reasonably expect the tax law to be in the relatively near future.

In most cases, it would take a very substantial decrease in income tax rates in order to offset the benefits of converting to a Roth IRA. While such a change is possible, I don't see any reason to bet on it.

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Bruce Steiner, attorney

(212) 986-6000 (NY office)

(201) 862-1080 (NJ office)

also admitted in FL

[Guest BJames]

Bruce,

Thanks for the response. A question please:

Why is it hard to collect sufficient revenue from high-income people under a VAT or NST system? Is it because they don't spend a large enough portion of their income on "consumption", and instead save or reinvest it?

I had always assumed that the NST rates would be based on current levels of GDP or GNP, such that the revenues they would generate would equal the loss of income taxes. In total the system should be a wash, but I can see that because high-income people don't spend as great a percentage of their incomes on consumption, their share of the overall tax load may decrease. Hence, why the actual transaction rate of the NST would have to be set high enough such that desired rates of taxation on high-income people are achieved, while still giving adequate credits to lower-income people so as not to overtax them. I'm not suggesting raising or lowering tax rates for anyone (that is an entirely different subject for other boards), just trying to imagine a system that keeps things in balance.

And finally, it seems to me that the largest incentive for an NST is to capture the legal and illegal activity that currently escapes any form of taxation at all. Could this make up for the loss of taxes because of the lower consumption rates (on a percentage basis) of high-income people? Of course, no one knows for sure, but I believe that many people think it could, and at the same time create an incentive to increase the savings rate in the U.S.

[John G]

Don't expect a NST to find all of the hidden or underground economy. We already have state and local sales taxes in most locations, and sales tax collection is a problem.

NST and VAT are dramatic shifts for the US. I don't see it happening. We probably can't get there from where we are today. And every citizen with significant ROTH assets becomes another opponent of these tax changes.

[This message has been edited by John G (edited 05-03-99).]

[Guest ezollars]

I find it interesting when people seem to believe that somehow a sales tax cannot be evaded. Putting on my financial statement auditing hat for a moment, I will note that confirmation of the completeness of reported revenue is the *toughest* issue to handle in any examination of an entity.

Just because there is an NST doesn't mean that all transactions subject to an NST would be reported. In fact, given the rates that would be required under most reasonable revenue neutral projections, there would be a sizable incentive to have sales occur "off the books" in order to evade the tax.

From a practical standpoint, I think the best you could hope for is that an NST wouldn't cause a net *increase* in uncollected taxes.

[Guest BJames]

ezollars,

Interesting assumption that merits some additional thought. It seems to me, however, that the point missing from your assumption is that it will require the complicity of at least one other person, in addition to the person trying to evade taxes on some portion of their consumption, in order pull off the "off-the-books" scheme you have suggested. While there will always be people/companies willing to do this, I'm not sure I can visualize the local Mercedes dealer, or resort, or department store, etc., willing to comply in order to gain a sale.

As the owner of a small business I am occasionally either directly asked, or have it indirectly implied, that I complete a sale without sales tax. Frankly, it's simply not worth the risk to me to consider doing this in order to be assured of the sale.

It is this sort of additional complicity that would be required in order for someone else to evade what will then be, essentially, federal income taxes. The consequences of participating in a scheme to evade federal taxes raises the stakes considerably for the accomplice, and while I'm sure you are correct that some will participate, I'm not sure that the owners of the establishments where the majority of our national consumption occurs will be willing to do so.

BJ

[Guest ezollars]

I don't need your complicity if I just pocket the sales taxes I collect (something which goes on today among some less than honest businesses). I have no way of knowing if anyone I, as a consumer, paid sales taxes to actually remitted those taxes to the taxing authorities.

While not wanting to do a "how to" discourse on tax evasion :-) , I would just point out that a business doing the above (collecting but not remitting tax) could obviously set a base price that was significantly lower than a business that was honestly collecting and remitting the tax. That especially true if the rate was in the mid to high 20% range, which is the most likely rates once you consider items that, for political reasons, would likely be excluded from an NST (such as real estate).

So I don't agree the collusion would be a necesary requirement for evasion of sales taxes, any more than it is a requirement for the evasion of income taxes. In fact, given the fact that there would not be source reporting of income, it seems to me that an NST requires less collusion to evade than does the current income tax.

[Guest BJames]

ezollars,

I may have been naive about the general level of compliance with tax laws. You're probably in a much better position than I am (being a CPA) to be aware of the potential magnitude (and ease?) of abuse. Perhaps part of my problem is that I have assumed that cheating on a federal tax program (assuming that an NST would be federally administered) would somehow be more difficult (and costly if caught) than "just" cheating on a state's sales tax. Of course this may be silly when one takes into account that the driving force of an NST is to catch the current non-reported income; if people aren't reporting today, what makes me think that they will report under an NST. One possible answer is that some of the cheaters under an NST are likely to be a different group of people than those who cheat under the income tax laws. But, I also think that you're correct in the 20%-30% level of an NST, and at non-trivial percentages like that, the temptation will be quite great for people to cheat.

Obviously, the compliance and enforcement issues may be much greater than I originally considered -- I'm feeling that the likelihood of an NST is even less than I had originally thought, and that my Roth distributions will probably be spent tax-free as originally assumed.

BJ

[Guest Lyric]

I think one of the reasons that a NST would not find favour everywhere is that it is in a sense regressive. A poor family may very well spend half its monthly income on housing, whereas it is unlikely that a wealthy family would spend half its monthly income on housing. This goes for running a car, clothing the family, not to mention food etc. And we're not even getting into luxuries here. This is why we have a "progressive" system of different tax brackets for different levels of income. A standard national sales tax would have a disproportionate effect on people with lower incomes.

A couple of years ago, when I was living in Arizona, there was talk of taxing snack foods, because these were not regarded as "staples" and were therefore fair game. The result of this would have been to tax lower income people for having chips and dip at parties, but not to tax wealthier people serving smoked salmon and strawberries at their parties. It is very difficult to impose sales taxes in a way that does not impose a proportionally higher burden on lower income people, even if they don't buy luxury goods or have high rates of consumption.

By the way, it may interest you to know that VAT (Value Added Tax) was first introduced in Europe as a way to finance the running of the Common Market. Since the core mission of the EEC (European Economic Community) was at that time economic and not political (to ease trade between countries), VAT -- a tax on trade in goods and services -- became the logical mechanism for raising revenue to finance the European institutions and regulatory process. VAT was never intended to supplement national budgets. For many years levels of VAT differed from country to country, but eventually they were "harmonized". (Now of course the European Union does have a political mission as well, but as far as I know, VAT still fuels the "Eurocracy", not the national bureaucracies.

As for a NST, if a variety of mechanisms had to be found to protect the incomes of people at the lower end of the economic scale, I can't see the tax code being a lot simpler than it is now. Moreover, there are so many issues that would have to be addressed that a radical change is not going to happen overnight -- if at all. I agree that it is pointless to plan for the eventuality that a NST will replace Federal income tax.

Roths are not risk free, but trying to predict what will happen to the tax code is like trying to time the market. We need to make decisions that make sense now, and adjust things later on if necessary. Remember that the very point of creating the Roth IRA system was to encourage people to save more for their retirement, by promising them certain benefits down the road. The $2,000 limit may even be raised. It suits the government to collect those taxes now rather than in 20, 30 or 40 years' time.

Still, with the weird things one sees in Congress, who knows what might happen ...? ;o)