Commentary: Why The Roth Needs A Revamp

If Congress were a business, it would be thinking hard about a relaunch of its latest financial product, the Roth IRA. This brand of individual retirement account, inaugurated a year ago, got glowing reviews and drew heavy showroom traffic. But sales have been mixed, hampered by stiff up-front taxes and confusing rules. The result: The hefty revenues Congress hoped to reap from the Roth's first year probably won't materialize.

Part of the 1997 Taxpayer Relief Act, the Roth put a new twist on the old IRA formula. Traditional IRAs let eligible savers deduct up to $2,000 a year in contributions from their taxable income and defer taxes on the account until the funds are withdrawn after age 59 1/2. Roth IRA deposits are not deductible, but earnings are exempt from taxes.

Many more taxpayers qualify for a Roth because Congress set higher income limits and didn't bar workers with employer-backed pensions from opening accounts. In fact, lawmakers thought Roth IRAs would be so appealing they gave owners of old-style IRAs the right to switch. If your income is below $100,000, you can cash out your traditional IRA and put the money in a Roth account without penalty. But you will have to pay income tax on the earnings and any deductible contributions in your old IRA. To soften that blow and encourage people to pay taxes that otherwise wouldn't be due for decades, Congress allowed anyone who converted in 1998 to spread the tax bill over four years. That option has now expired.

While a majority of IRA holders could profit by switching to a Roth, mutual funds and brokerage firms say fewer than 10% of their IRA clients converted last year. True, a rush to convert before the yearend boosted the numbers some: Vanguard reported 3,000 calls about conversion a day, or 150% over the predicted volume, in mid-December. Even with that surge, "we're didn't see the conversions we expected," says Christine S. Fahlund, a financial planner at the T. Rowe Price fund family.

RAISE INCOME LIMITS. Congress is to blame. Financial planners say a one-year window for converting and spreading out the taxes didn't give enough time to educate clients on the benefits of switching. The notion of paying rather than postponing taxes "runs counter to everything we normally tell clients," says Dee Lee of Harvard Financial Educators in Harvard, Mass. Many IRA clients fear Congress will renege on its vow to exempt Roth IRAs from taxes forever.

That's not likely, because the baby-boom constituency for Roths, 401(k)s, and other retirement accounts will form a powerful pro-savings political bloc. But Congress should extend 1998's special tax treatment for IRA converters who act between now and the end of 2000. It should eliminate confusion by creating one set of income limits for conversions and new accounts. And it should raise new-account income ceilings--now $150,000 for couples, $95,000 for singles--and let savers put up to $5,000 a year into a Roth IRA.

These changes are essential if Congress wants interest in Roth IRAs to build. The demand is certainly there: Merrill Lynch's IRA volume has already doubled from 1997 to 1998, with Roth IRAs making up 30% of the total. "It stimulated interest in all IRAs, without cannibalizing the traditional accounts," says Jim McCarthy, Merrill's manager of tax-product development. Firms expect another surge of interest before Apr. 15, the deadline for making a contribution to a 1998 account. Congress needs to improve the Roth IRA so that these surges can turn into a steady flow of funds and help boost Americans' woeful savings.

Before it's here, it's on the Bloomberg Terminal.