Proposals Seek to Retool IRAs to Boost Savings

A decade after Congress curtailed a popular retirement savings tax break for millions of Americans, new incentives to save are popping up again like worms after a spring rain.

Legislation now moving through Congress would expand the availability of individual retirement accounts, create new kinds of tax-deferred savings accounts and allow new uses for IRA savings.

Those changes, part of the tax-cut bills going before the House and Senate next week, would provide at least $36 billion in tax breaks over the next 10 years for all taxpayers, regardless of income.

Proponents hail these initiatives as a way to boost national savings and prepare for the retirement needs of the baby-boom generation.

“Increasing our country’s meager savings rate is the single most important element of creating growth and jobs in our economy,” said Senate Finance Committee Chairman William V. Roth Jr. (R-Del.), Congress’ most ardent and influential supporter of IRAs.

The retirement account renaissance is proceeding despite doubts expressed by many economists about whether such tax breaks really increase savings or just provide a windfall for affluent people who would save in any case. “This is a concept run amok,” said Robert D. Reischauer, a budget expert at the Brookings Institution. “It gives a lot of opportunities for people who already save to save that money in a tax-advantaged way.”

The broad political support for these proposals is, in part, a tribute to the clout of the middle- and upper-income people who would be most likely to benefit. In 1986, when tax-deductible IRAs were available to taxpayers at all income levels, 82% of the deductions were taken by the wealthiest third of individuals filing, according to a report by the Congressional Research Service.

Now, however, the full tax advantages of setting up an individual retirement account are available only to couples with incomes of less than $40,000 and single taxpayers with less than $25,000 annual income and to people who are not covered by a pension plan. Eligible taxpayers can contribute up to $2,000 a year to an IRA and deduct it from their taxable income. No tax is paid on the investment earnings until the money is withdrawn in retirement. Taxpayers must pay a 10% penalty if money is withdrawn before they reach age 59 1/2.

That generous tax advantage--the ability to shelter $2,000 a year from taxes while saving toward retirement--used to be available to all taxpayers, regardless of income. That ended in 1986, when Congress overhauled the tax code to eliminate many special preferences and tax shelters. The resulting law included the income limits on who can take IRA deductions, which became one of the hardest-fought issues of the 1986 tax reform debate.

Although more affluent taxpayers are no longer allowed to take the deduction, they can still put money into IRAs and have the interest accumulate tax-free until it is withdrawn in retirement.

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Suddenly, IRAs are returned to center stage as Congress drafts legislation to carry out the budget agreement between Clinton and GOP leaders. Although lawmakers are not likely to restore IRA deductions for everyone, a raft of new savings incentives are included in the tax-cut bill approved by the House Ways and Means Committee last week and a similar bill that the Senate Finance Committee completed work on Thursday night.

While the White House and Republicans have been squabbling over many features of the tax-cut bill--such as details of a proposed $500-per-child tax credit for families--there has been virtually no dispute over proposals to provide new incentives for savings. Among the major proposals on the table:

Retirement savings. The House bill would create a new kind of IRA for retirement savings, providing a big tax break when the money is withdrawn rather than when it is put into the account. This new “back-loaded” IRA would allow interest to accrue and be withdrawn tax-free. But deposits would not be deductible. The Senate bill contains a similar proposal.

In another provision affecting retirement savings, the Senate bill would expand the availability of traditional IRAs by raising the income limit on who can take the $2,000 deduction for savings. The income limit for couples would rise in steps from $40,000 now to $80,000 in 2004. For single filers the limit would double from $25,000 to $50,000 by 2004.

Education savings. The House bill would create a new IRA-like account for savings dedicated to college expenses. The bill would allow taxpayers to put up to $5,000 a year--up to a maximum of $50,000--into an “education investment account.” Earnings would accumulate tax-free. When the money is withdrawn for college expenses, taxpayers would not have to pay taxes as long as they do not withdraw more than $10,000 a year in earnings. A similar proposal is included in the Senate bill.

New uses for IRAs. Both the House and Senate bills would allow people to withdraw money, without penalty, from their existing IRAs to pay college costs. They also would allow taxpayers to withdraw from the new “back-loaded” IRAs to help first-time home buyers pay for a house.

Proponents of these proposals say such changes are needed to help increase Americans’ lagging savings rate.

“In the absence of these incentives, some people are lazy savers,” said Kenneth Kies, chief of staff of the Joint Committee on Taxation. “This causes some people to save money they would otherwise consume.”

Proponents say there is a particular need for expanded incentives to save for retirement because the aging of the baby-boom generation is expected to strain the Social Security system.

“Given the upcoming retirement boom, we need to do everything possible to prepare for retirement,” said Ari Fleischer, spokesman for the House Ways and Means Committee.

But economists are divided about whether IRAs actually increase the amount people save. Jonathan Skinner, an economist at Dartmouth College, said he believes at least half of the money put in IRAs would not have been saved in the absence of tax incentives. He cites his own experience as an example: He set up an IRA for the first time one year when he was preparing his tax return and found he owed the government a lot of money. He eliminated the tax liability by setting up an IRA and deducting the $2,000 from his taxable income.

“I would have never opened such an account if I hadn’t had the prospect of getting a deduction,” said Skinner.

Other economists are skeptical, arguing that most money put in IRAs would have been saved anyway.

“The existing body of economic theory and empirical research does not make a convincing case” that expanding IRAs would increase savings, said Jane G. Gravelle, an economic policy specialist at the Congressional Research Service, in a 1995 report on the issue.

She said “back-loaded” IRAs are even less likely to induce new savings because the tax advantage does not come until retirement. However, that delayed tax benefit has an important advantage for budget writers: It postpones the biggest revenue losses until far in the future, so the full cost of the new IRAs will not hit until far past the five years covered by the current budget agreement.

Some analysts question the wisdom of these proposals on grounds that the savings incentives tend to benefit higher-income people.

According to Gravelle’s report, fully deductible IRAs were most popular with taxpayers in upper-income brackets: 70% of taxpayers in the wealthiest 1% of filers contributed to IRAs in 1986; only 2% of taxpayers in the lowest one-third contributed.

But IRA proponents say that there are broad economic benefits to increased savings. “A higher saving rate will help create low-cost capital to finance improvements in our country’s manufacturing capacity, technology and worker training,” Roth said. “In short, this means more jobs for more Americans.”

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Figuring Out the New IRAs

The tax bills making their way through the House and Senate provide new or expanded tax breaks for long-term savings. The provisions would expand existing Individual Retirement Accounts and create two new categories of tax-sheltered savings:

Traditional “Front-Loaded” IRAs

How they work: Individuals contribute up to $2,000 per year; couples up to $4,000. Contributions deductible for qualifying account holders. Investment earnings accumulate tax-free. Withdrawals after age 59 1/2 subject to income taxes. Earlier withdrawals subject to 10% penalty.

Current law: Deduction for contributions phased out for single taxpayers earning more than $25,000, and married taxpayers earning more than $40,000.

Pending legislation: House and Senate bills allow penalty-free withdrawals before age 59 1/2 for college costs. Senate bill gradually raises income limits for deductible contributions to $50,000 for singles and $80,000 for couples.

Estimated cost: Up to $1.7 billion over 10 years for higher education withdrawals. About $11 billion over 10 years for increased income limits.

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New “Back-Loaded” IRAs

How they work: Individuals contribute up to $2,000 per year; couples up to $4,000. Contributions not deductible. Earnings accumulate tax-free. No taxes paid on withdrawals after age 59 1/2, earlier withdrawals for disability or first home purchase, or any funds held at least five years.

Current law: Deduction would not be allowed.

Pending legislation: Both tax bills authorize back-loaded IRAs (“American Dream” IRAs in the House, “IRA-Plus” accounts in Senate).

Estimated cost: About $13 billion over 10 years.

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New Education Investment Accounts

How they work: Accounts earmarked for higher education expenses. Contributions not deductible. Earnings accumulate tax-free. No taxes paid on qualifying withdrawals.

Current law: Deduction would not be allowed.

Pending legislation: House bill allows non-deductible contributions of $5,000 a year and $50,000 over a lifetime. No taxes unless more than $10,000 in earnings withdrawn in a single year. Senate bill allows $2,000 annual contributions.*

Estimated cost: $22 billion over 10 years for House plan; $18 billion for Senate proposal.

Source: House Ways and Means Committee, Senate Finance Committee.

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COMPARING PAYOFFS AFTER 20 YEARS

(based on contributions of $2,000 per year, compounding annually at 8% over 20 years.)

Traditional “Front-loaded” IRAs

Account balance at retirement: $98,846

Taxes paid on lump-sum withdrawal: $19,419

Net available for retirement: $79,427

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New “Back-loaded” IRAs

Account balance at retirement: $98,846

Taxes paid on lump-sum withdrawal: none

Net available for retirement: $98,846.

Note: The calculation for front-loaded IRAs does not reflect the initial tax benefits of deductible contributions for qualifying taxpayers.

Source: Holthouse Carlin & Van Trigt, Certified Public Accountants, Los Angeles.

* House bill calls for no taxes unless more than $10,000 in earnings withdrawn in a year. Senate bill calls for no taxes on withdrawals.

Note: The calculation for front-loaded IRAs does not reflect the initial tax benefits of deductible contributions for qualifying taxpayers. Payoff for education investment accounts unavailable.

Source: House Ways and Means Committee, Senate Finance Committee, Holthouse Carlin & Van Trigt, Certified Public Accountants, Los Angeles