Tax Reform: Don’t Discourage Much-Needed Retirement Saving For Economic Growth
Published in Financial Advisor
April 15 is around the corner and if the burden of time and complexity on America isn’t enough to encourage a new code, our weak economic recovery, stagnating incomes and the ever-increasing national debt should be. Times are changing and international competition is much more fierce compared with 1986, when the last major tax reform was passed.
Unfortunately, the recent release of a comprehensive tax reform plan by House Ways and Means Committee Chairman Dave Camp has received a lukewarm welcome from both sides of the aisle, largely due to a lack of political appetite in an election year. Rightly, Camp’s tax reform proposal aims to simplify the tax code and grow the economy. So this unapologetically detailed and comprehensive plan may be the launching pad for any serious tax reform discussion in the coming years.
In order to talk about comprehensive tax reform with lower rates, some of the major and undoubtedly very popular tax expenditures come to the chopping block, and that is where the water gets muddy. On the individual side, one of these items is tax-deferred retirement accounts in which individuals save money tax free, although they will pay taxes when the funds are withdrawn. According to the most recent budget, the size of the tax expenditure associated with 401(k)-type plans is $414 billion between 2015 and 2019.
Recent tax reform proposals have targeted these accounts in order to raise revenue to pay for other parts of their plans. Previously, the National Commission on Fiscal Responsibility and Reform Plan in 2010 proposed limiting tax-deferred contributions (including the employer’s share) to the lesser of $20,000 a year or 20 percent of income.
President Obama’s fiscal year 2014 budget proposes limiting the accumulation in IRAs and other tax-preferred retirement accounts to $3 million which was based on the amount sufficient to finance an annuity of not more than $205,000 per year during retirement. He also proposed limiting the benefits of tax breaks, including retirement tax preferences, for high income households to a maximum of 28 percent.
While Chairman Camp’s approach retains some portion of tax deferred accounts, it is more Roth-centric, whereby individuals would save after-tax money and have no tax obligation when funds are withdrawn during retirement. He proposes to limit contributions to tax deferred accounts to $8,750 and to direct any amount in excess of that up to the current contribution limit of $17,500 to Roth style accounts. The implication of this plan would depend on an individual’s tax bracket during their working and retirement years. If, however, both rates are the same, the savings under both plans would be equivalent. Also eliminating income eligibility limits for Roth contributions, gives individuals flexibility in terms of tax diversification in their retirement years.
The plan also stops any new contribution to traditional IRA’s to encourage the shift to Roth IRAs. However, taking away the upfront tax incentives might discourage some workers from saving. In fact, EBRI’s 2011 Retirement Confidence Survey asked “Suppose you were no longer allowed to deduct retirement savings plan contributions from your taxable income. What do you think you (and your spouse) would be most likely to do?” One in four survey participants indicated that they would either completely eliminate or would reduce their contributions to retirement savings plans.
Then there is the tax revenue implications of Camp’s plan: By mainly promoting Roth plans, revenues are shifted to a current 10-year budget window from outer years. With changing demographics, that could mean lower tax revenues in future years. When money is needed, we know Washington can get very creative and that could bring these plans to the table one way or another. For long-term savings, continuous rule changes could damage the credibility of these accounts. That would be another chink in the savings armor.
This latest proposal gives us another flavor of the possible tax reform options in the retirement arena. In an ideal world, if all savings and investment were tax exempt, such as under a progressive consumption tax, retirement savings would be much easier for everyone. In addition, past research proves that switching to a tax base that primarily depends on consumption rather than income could not only increase saving and investment, but also real output and long-run economic growth.
There is a lot that Congressional leaders can do, but what they should not do is inadvertently discourage much-needed savings that would not only help retirees, but would also put the country on a much needed path toward healthy economic growth. So it is time to pay attention to each provision and start weighing the long-term costs and benefits.
Dr. Pinar Çebi Wilber is a senior economist for the American Council for Capital Formation, a nonprofit, nonpartisan organization promoting pro-capital formation policies and cost-effective regulatory policies (www.accf.org).