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Volume III, Number 44 February 2003

Joe Millionaire

Tim Francis-Wright

This week, the Bush administration offered another radical change to an aspect of tax policy. It proposed to replace most of the current smorgasbord of tax-deferred savings plans for retirement and education with a simplified system that features only three options. Like the proposal to eliminate income tax on most corporate taxes received by individuals, it does little to solve a problem or rectify an inequity facing ordinary Americas. But it does benefit the trust-fund set, and in a big way.

The Bush savings plan would establish three accounts: Lifetime Savings Accounts that could be used anytime and for any purpose; Retirement Savings Accounts that would replace all sorts of Individual Retirement Accounts; and Employer Retirement Savings Accounts that would supersede 401(k) and similar retirement plans. The nasty implications of the plans are buried in the details, and the details make the plan ideal for millionaires and lousy for everyone else.

Lifetime Savings Accounts

These accounts would supplement but not replace replace medical savings accounts, education savings accounts, and college tuition savings plans. Most users of these existing plans are middle and upper class taxpayers who are saving for the college education of a child or other relative. All limit the use of withdrawn money for certain purposes. The new Lifetime Savings Accounts would have $7,500 annual limits on contributions, no tax deductions for contributions, no taxes on withdrawals, and no restrictions on the time or amount of withdrawals.

Rich taxpayers will use these accounts as quickly as possible. Their first $7,500 of savings each year will go into these accounts, because there is no penalty for making quick withdrawals. And the rich are exactly the taxpayers who have $7,500 lying around, not just for retirement savings, but for anything from rainy day funds to stock market speculation. Joe Millionaire has that kind of money at the ready.

The Lifetime Savings Account will make the children of rich taxpayers very happy, perhaps only at the expense of the trust departments at law firms. As Nathan Newman has noted, this account is an ideal way to let the trust-fund set indefinitely earn tax-free income. Under current law, parents or other relatives can contribute up to $2,000 to an education savings account for a child, or contribute even more to a state tuition savings plan. The Bush plan will continue to allow these contributions, but it would also allow aggregate contributions of up to $7,500 to a child's account, with no pretense of saving for college at all. Nowadays, Joe Millionaire's kids often have trust funds, but trust funds generate taxable income (for either the trust or the beneficiaries), and require exacting legal documentation. A Lifetime Savings Account will make trust funds optional. By the time he or she reaches the age of majority, every rich kid will have a tax-free trust fund larded with 18 installments of $7,500 (adjusted for inflation). This account will provide tax-free withdrawals for as long as the investments hold out.

Retirement Savings Accounts

Under current law, most taxpayers can contribute up to $3,000 into an Individual Retirement Account (IRA). Most taxpayers not covered by retirement plans at work can deduct their IRA contributions from their taxable income. Those with less than $34,000 of adjusted gross income ($54,000 for married taxpayers filing joint returns) can deduct their IRA contributions even if they have retirement plans at work. The funds in an IRA accumulate free of taxes until withdrawal, when all funds, except for any nondeductible contributions, are taxed as ordinary income. Traditional IRAs have several problems for typical taxpayers. First, the tax advantages that investors enjoy or expect—lower tax rates for capital gains or the planned tax exemption for dividends—do not apply to them. Second, the tax deduction for a contribution is worth the least, 10 to 15 cents on the dollar, to low-income taxpayers, who need it the most. Third, most low-income taxpayers simply have trouble saving enough money to make an IRA worth the effort. (The last two problems might be ameliorated with a newly effective tax break that offers a 50% credit for low-income taxpayers who contribute to retirement plans. About the only worthwhile element of the overhaul of retirement savings is that it keeps this tax credit in place.)

The Roth IRA, introduced five years ago, provides another wrinkle. It has the same contribution limits as a regular IRA, but it has two very important differences. While almost all taxpayers can open a regular IRA, a Roth IRA has strict income limits, first applying at $95,000 for single taxpayers and $150,000 for married taxpayers. Second, taxpayers cannot deduct contributions to a Roth IRA, but any withdrawal is tax-free. The tradeoff between an immediate tax deduction and perennial tax deferral is an easy one for an affluent taxpayer, but a difficult one for a working-class taxpayer trying to save for retirement. For taxpayers who are well-off enough to have $3,000 to tuck away, but not so wealthy to breach the income limits, the Roth IRA is a gold mine, if they invest wisely.

The new Retirement Savings Accounts would take the worst aspects of the Roth IRA and make it applicable to all taxpayers. Low-income taxpayers would not get a deduction for their contributions, because traditional IRA accounts would be closed to new contributions. The annual limit on contributions would be $7,500, far above the current $3,000 limit. This is a meaningless increase for most working-class taxpayers but a twofold boon for the rich. Not only can they contribute $4,500 more per year than they can now, but they now can enjoy all of the main benefits of the Roth IRA even if they earn far above the current Roth IRA income limits. Perhaps someone in the Bush administration is convinced that the impetus for the proposal is the concept of helping millions of working-class Americans by eliminating the deduction for IRA contributions. More likely, the Bush administration knows exactly which Americans have $7,500 ready to invest each year. Joe Millionaire has that kind of money at the ready.

Employer Retirement Savings Accounts

The Bush plan will essentially replace all employer retirement accounts with one-size-fits-all Employer Retirement Savings Accounts. This aspect of the Bush plan is mostly window-dressing, because Congress has, quite rightly, passed several laws in the past few years that make these plans more like each other. For example, workers leaving jobs with 457 plans can now roll their plan balances into IRA accounts, a 401(k) account, or into any other qualified retirement plan.

The "blue book" of explanations from the Treasury Departnment trumpets the simplification of the current morass of rules regarding retirement plans, with particular emphasis on providing a simple solution to meeting the "top-heavy" rule regarding 401(k) accounts. The top-heavy rule ensures that tax-deferred corporate retirement plans do not disproportionately benefit its top employees. In the past, complying with the top-heavy rules often meant unhappy surprises for some managers, who found that some of their 401(k) contributions could not stay in their plans. Nowadays, however, companies can avoid the top-heavy rules by contributing 3 percent of each employee's pay to his or her retirement plan, regardless of how much overall benefit goes to the top employees. This alternative solution to the top-heavy rule, a solution introduced by the Clinton administration and now already in effect, is the centerpiece of the Bush administration's touted simplification plan.

A pitfall in the proposal for Employer Retirement Savings Accounts is that it would allow the immediate introduction of Roth ERSAs, which would have the same limits as current 401(k) accounts—or the planned regular ERSAs—of $12,000 in contributions per year. Contributions to a Roth ERSA would not reduce taxable income, but withdrawals froma Roth ERSA would not be taxed, either. For affluent workers or owners, a Roth ERSA is heaven-sent. They can afford to pay taxes on their contributions, and dearly hope to accumulate lots of money in their tax-free accounts to lavish on their heirs. For rank-and-file workers, the decent aspect of a 401(k)—that contributions aren't taxed currently—goes away entirely.

Another pitfall in the plan writ large is how it will affect the employees of small businesses. A huge incentive for owners of small businesses to establish retirement plans for their employees is that they offer the owners a chance to make large retirement contributions for themselves that they would not otherwise be able to do. Deferring a large chunk of income from taxes by establishing a retirement plan has substantial appeal to many small employers, even if they ignore the upside to their employees. But the Lifetime Savings Account and the Retirement Savings Account would allow those same owners to sock away $15,000 for retirement without doing a thing for their employees. Some small employers will find that $15,000 (or $30,000 if they are married) to be more than enough, and will neither establish nor continue retirement plans for the work and file.

The Bush administration's plan should be dead on arrival in Congress: but that is a normative statement, not a predictive one. Most Democrats should oppose it, because they rely on the poor and middle class for their votes. Some Republicans should oppose it, because it will drastically cut income from interest and capital gains for the foreseeable future, and thus worsen the deficit. The plan may well stagger through Congress with some of its key provisions intact. Those who support even some of those provisions will have cast their votes for trust-fund babies over working-class babies, and for Joe Millionaire over Joe Six-Pack.