By Rosilyn H. Overton, CFP CRPS
President Bush is trying to abolish 401(k) plans. He also wants to abolish IRAs, SIMPLEs, Section 457 Deferred Compensation plans, and the Tax-Deferred Annuities.
Yes, he wants to replace them with Lifetime Savings Accounts (LSAs), Retirement Savings Accounts (RSAs) and Employer Retirement Savings Accounts (ERSAs), but these are very different, and will completely abolish the one major way that middle-class Americans have to defer taxes.
Instead, they all will work the same way that Roth IRAs do presently — you pay tax now, then pay no tax when you take it out. And, there is no required holding period.
Sounds great, but while this can be beneficial if your tax bracket in retirement is higher than it is now, the major impact is to give a big boost to government revenues from income tax now, with devastating results when the Baby Boomers start to retire. If you, like many New Yorkers, plan to retire to a state with lower state income taxes, the net effect on your retirement income will be negative.
First, the facts: The President’s proposal is to give everyone, regardless of age or income, the ability to put up to $7,500 into a Lifetime Savings Account, and $7,500 into a Retirement Savings Account. This is after-tax money, and you can take your contribution and earnings out of a LSA at any time for any reason. RSAs are meant for retirement, so you can’t take the money out until age 58 (or on death or disability). In either case, you pay no income tax when you take it out. There is no required age for retirement distributions, so if you have lots of other retirement income, you can let the money continue to accumulate. You will be allowed to convert your present IRAs, SIMPLES, 401(k) etc. money into the new accounts if you are willing to pay the taxes now.
In addition, employers can also set up ERSAs, whereby employees can contribute up to $12,000 plus a $2,000 catch-up for employees over 50. Safe-harbor anti-discrimination rules will encourage employers to make matching contributions of at least 3 percent of compensation. All top-heavy provisions will be abolished if the Bush plan take effect.
What does this mean to the average resident of Queens? There are so many uncertainties about what tax rates will be in the future that I think that we may have to ignore the negative effect of paying tax at a higher rate now than at some time in the future. It is probably more likely that tax rates will go up further than going lower. From a personal point of view, if you have the money to take advantage of these new rules, it is a good thing. Everything you put into savings now for retirement, plus your earnings, will be tax-free when you need it. I plan to take advantage of this to the hilt if it passes and sock away the money like crazy.
However, most people are not taking advantage of the full $3,000 contribution limit on their IRAs, or the limits on their 401(k)s, when nearly 40 percent of the money that goes into these accounts is money that they would pay in taxes anyway. The plans will primarily benefit those who make enough money to save after-tax. For example, leaving aside the education and medical accounts, which would be allowed to continue or be rolled into one of the new ones, a family of four working for employers with ERSAs could contribute $15,000 to the LSAs, $15,000 to the RSAs, $24,000 to their ERSAs and $15,000 for the two kids. That’s $69,000. Not very many people can afford to make that kind of contribution.
In the meantime, the effect on tax revenues to the Federal government would be immediate. According to the National Bureau for Economic Research, “While many types of retirement programs have had an important impact in increasing retirement saving, the employer-sponsored 401(k) plan has been the single most important source of growth. The number of active participants in-creased from essentially no participants in 1981 to nearly 40 million active participants in 1997. This is a sizable fraction of the entire U.S. labor force. Active participants in 401(k) plans make an average annual contribution to their plan of over $3,000. Total annual contributions to 401(k) and other similar plans reached $176 billion in 1999.”
Okay, assume that the bill passes. What is the effect on the federal budget? That would be $176 billion dollars more tax funds circulating in the economy, starting almost right away. If you assume that approximately 25 percent of that is paid in taxes, you have additional revenues to the federal government of $44 billion. If you assume 30 percent goes to federal taxes (a number that we think more likely since most of the big contributors to 401(k) plans are in at least the 27 percent tax bracket, and most in the 30.65 percent bracket.), the increased revenues are $52.8 billion. That could buy a few fighter planes without increasing the deficit, something that the president has to be thinking about. This is just revenue from 401(k) contributions that are now suddenly taxable contributions to ERSAs, and doesn’t include the billions that now go into IRAs, SIMPLES, 457 plans and teacher annuities.
There is a time bomb, however. The oldest baby boomers are now in their 50s. In 10 to 15 years, most will be retiring and starting to make withdrawals from their IRAs and 401(k) plans. Once again, according to the National Bureau of Economic Research, as of 1999, there were 12 trillion in 401(k) plans alone. Even allowing for the devastating effects of the recent bear market, if you assume that there is still $6 trillion, that is another source of new income tax dollars if people convert now, and a consequent drop in future tax revenues as people withdraw non-taxable money. While many will just let their money sit and pay taxes when it comes out, the most affluent will race to take advantage of this opportunity for future tax-free withdrawals.
All in all, there is an advantage to any society that encourages savings, so the new plan is mostly good. However, do not think that there is no price to pay. Future taxes will probably have to go up to make up the difference in future revenues. All the more reason to personally take advantage of these new plans if the bill passes.
Rosilyn H. Overton is a Certified Financial Planner and Chartered Retirement Plan Specialist at Mid-Atlantic Securities, Inc. (Member, NASD & SIPC) in Little Neck. She can be reached at 718-631-4000.
