Congress May Expand Tax Breaks on IRAs

Congress is weighing a massive expansion of tax breaks for those investing in individual retirement accounts as part of a sweeping urban renewal and tax bill that’s likely to be debated on the Senate floor as early as this week.

The retirement account changes, which would also dramatically liberalize rules relating to these accounts by allowing individuals to use retirement funds for current investment in housing, health care and education, have widespread support despite the fact that they are likely to cost the government $7.75 billion over a five-year period, Senate insiders say.

Although tax legislation passed by the House currently does not deal with IRAs, it is likely that IRAs will be a key issue when the two houses of Congress meet to work out the differences in their respective tax plans later this year.

If the changes go into effect as they are now proposed, they could drastically increase the number of individuals who are willing and able to invest in these tax-favored retirement accounts, experts say. Some believe that they could also spur the economy by releasing billions of dollars in retirement savings for immediate investments.

“We see very few people making non-deductible IRA contributions today,” said Philip J. Holthouse, partner at the Los Angeles tax accounting firm of Holthouse, Carlin & Van Trigt. “If everyone can deduct their IRA contribution, I’m sure it will significantly increase the number of people who will take advantage of it.”

Right now, IRA deductions are available only to those who earn less than $25,000 individually or $40,000 as a couple, or who are not covered by another pension plan. In addition, withdrawals from IRAs are severely limited. Those who need to tap into their IRAs before they reach the age of 59 1/2 must pay federal and state taxes on the withdrawals, as well as a 10% penalty tax.

For those who can’t deduct contributions, the main benefit of today’s IRA accounts is that interest earned on IRA deposits are not taxed until the money is withdrawn. In other words, you can earn interest on money that would otherwise have been paid to Uncle Sam. Over time, that can make a huge difference.

Someone paying 32% in combined state and federal taxes would see a $10,000 deposit grow to $49,268 if it were in an IRA, for example, but the same deposit would amount to $29,610 if this individual was paying tax on the interest earnings each year. Of course, the IRA would be taxed when it was withdrawn at retirement but by then the saver’s tax bracket may have dropped since he would be no longer working and earning a salary.

But the Senate bill promises to make that deal quite a bit better by doing three things:

* Restore tax deductions on IRA accounts for all Americans, regardless of their income. The new law would also boost the tax-deductible limits by $500 per year. Maximum deductions are now limited to $2,000 per person per year.

* Create a new type of IRA account, which would not allow for up-front deductions, but would allow individuals to withdraw their money after five years without penalties and without paying tax on their interest earnings. Currently, those who withdraw IRA money before they turn 59 1/2 must pay a 10% penalty. In addition, federal and state taxes are assessed on principal and interest earnings withdrawn from deductible IRAs.

* Finally, the law would allow penalty-free withdrawals from either type of IRA if savers used the money for one of four reasons: to buy, build or remodel a first home for themselves, their children or grandchildren; to pay for a child’s or grandchild’s college tuition, fees and books; to pay for deductible medical expenses, or to help long-term unemployed individuals handle day-to-day living expenses.

Sen. Lloyd Bentsen (D-Tex.), one of the main proponents of the IRA legislation, maintains that this provision could spur the nation’s moribund housing market and provide tens of thousands of jobs virtually overnight.

“Americans and America’s economy need the savings, investment, housing and new jobs created by a restored IRA,” Bentsen said. “We need to put it back into play because it can do something that few other economic actions can--make an immediate difference in our lives without adding to the deficit.”