President Bush has proposed sweeping changes in taxation of retirement and other savings. If enacted, his proposals could profoundly affect the way Americans save. It could also lead to major federal and state budget deficits in the future.
The proposal is far more important to most working and retired Americans than is the proposed elimination of dividend taxation. Bush’s plan would allow savers to convert over time most or all of their savings to tax-free accounts. This would sharply reduce, or even eliminate, the federal taxes Americans pay on their savings.
Bush wants the confusing and complex tax-deferred retirement savings system to be simplified into three tax-advantaged accounts. Wait a minute… did someone just say “simplified?” No way! The addition of these accounts will make a confusing situation even more complicated. It will multiply the numbers of savings and investment accounts held by ordinary Americans and will make them subject to a wide range of tax rules.
It is far too early to tell whether Bush will get what he wants, but retirement savers should sit up and take notice because the President holds a majority in Congress and because these proposals will be popular in some quarters (but unpopular in others). There are steps taxpayers should take now while waiting for the outcome:
- Delay making 2003 IRA contributions. Go ahead and make contributions for the 2002 tax year (you have until April 15 to do that). Hold off on new contributions until we see what rules are adopted—in many cases, you may want to make contributions to the new accounts instead of your current IRA.
- Monitor your 401k contributions. If your employer matches your contribution up to a certain level, continue to make contributions until you get the full match. However, if Bush’s proposal is adopted, you may want to stop making contributions past that level and instead put them into one of the new accounts.
- Hold off on investing in medium to long-range municipal bonds. Their values may decline if competing tax-free savings accounts are created.
Bush wants to create two tax-free, individual savings accounts: Lifetime Savings Accounts (LSAs) and Retirement Savings Accounts (RSAs). First, the Lifetime Savings Account is a supercharged personal savings account. All earnings would be free of federal income tax. Principal and earnings would be available for use at any time, whether you are working or retired, young or old. Anyone would be able to contribute up to $7,500 per year to his or her account, regardless of income, age, or employment status. Anyone could contribute up to $7,500 per year to someone else’s account as well. Second, the Retirement Savings Account would replace the traditional deductible IRA, the non-deductible IRA, and the Roth IRA. The Retirement Savings account would allow working Americans to contribute up to $7,500 of their incomes to a tax-free retirement account. As long as they earn up to $7,500, they could contribute that amount. There would not be upper income limit on contributions as there is now with Roth and deductible IRAs. The only restriction would be that money must be kept in the account until age 58. A working spouse could also contribute up to $7,500 to an account for a non-working spouse.
The third account—the Employer Retirement Savings Account—would replace 401(k) plans, 403(b) plans, Simple IRAs, SEP IRAs, and 457 plans. It would be similar to a current 401(k) plan, with a contribution limit this year of $12,000, plus $2,000 for employees over age 50. After-tax contributions over those limits would also be allowed. Employers would get relief from a lot of the non-discrimination rules that forced them to include all employees in retirement plans and encouraged employers to promote employee participation.
As noted above, no one knows whether Bush’s proposal will become law. If it does, you should expect to see the following changes:
- Many Americans will set up Lifetime Savings Accounts by shifting currently taxable savings into the new accounts.
- Many may take advantage of a proposal to allow them to shift college savings into LSAs from state-sponsored 529 plans and Coverdell Education Accounts (the former “education IRAs”). Transfers will be allowed only until the end of 2003.
- The rules allow anyone to make contributions to an LSA or RSA on behalf of another person, without limit. Rich grandparents and parents may make as many $7,500 contributions to accounts for children and grandchildren as they wish. If the recipients also have earned income, they can receive contributions for others for their RSAs as well.
- Some Americans may stop contributing to their retirement savings. The proposal eliminates tax-deductible contributions to IRA accounts. Those tax deductions enabled many lower income workers to contribute.
- Although existing deductible IRA accounts would be convertible into the new RSAs, income tax would be paid on the conversion. Many IRA holders won’t pay the tax and will continue to hold their IRAs.
- There will be a scramble to convert IRAs this year because a special rule would allow the taxes on 2003 conversions only to be paid over four years.
- An employee who retires and can roll over a tax-deferred plan will now have to decide whether it is better to put it into an IRA and continue the tax deferral, or to roll over into an RSA and pay immediate taxes. A two-tier retirement savings system will develop.
Here are some potential problems and questions that remain unanswered:
- How much will this proposal contribute to future federal budget deficits? Bush’s plan would forego future taxation on billions of dollars in earnings on the new tax-free accounts.
- Will the government find another way to tax this money in the future? What if a consumption tax replaces the income tax? That move would make suckers out of those trusting taxpayers who pay tax now to convert existing tax-deferred accounts into the new tax-free accounts.
- Will this mean the end of 529 college savings plans?
- How will the states treat the tax issues—will they go along with the federal model, or will they continue to tax earnings on savings?