Tax Refund

Have you seen the new movie Spirited, the musical take on Charles Dickens’s A Christmas CarolIn the film, the Ghost of Christmas Present shows it’s possible to redeem the irredeemable. They just have to choose to “do a little good” and “give a little more” because “a little is enough.” The movie got me thinking about Congress and retirement savings. Hear me out. (I promise I won’t sing.) 

Doing a little good by helping people save for retirement.

Most Americans do not save as much as they need for retirement. Financial planners often suggest workers should save about 10 times their annual income by age 67 or put away enough to cover about 80 percent of their pre-retirement earnings. 

But the investment firm Vanguard estimates that half of Americans aged 55-64 have less than $90,000 in retirement savings, while the average savings for that age group is about $250,000. (If you turned that $90,000 into a lifetime annuity, it would give you less than $500 a month.) 

Meanwhile, there are too many Americans of retirement age who have not been able to save at all. The supplemental poverty rate (which accounts for differences in housing costs, homeownership status, geography, and family size and composition) among those over age 65 rose from 9.5 percent in 2020 to 10.7 percent in 2021. 

Congress is considering legislation that may help some low-income workers save. But it may miss a chance to do a little more good by ending a tax benefit that allows the very wealthy to accumulate savings tax-free. The lost revenue from those unnecessary subsidies could instead help people who not only need to save more but also need to earn enough to save in the first place.

Congress: A history of giving some help, and maybe soon giving a little more.

Almost a half-century ago, Congress created tax-advantaged individual retirement accounts, or IRAs. Later, it allowed work-based plans such as 401(k)s and an alphabet soup of similar plans such as SEPs, SIMPLEs, and individual 401(k)s. All allow pre-tax contributions. Taxes are deferred until savers take taxable distributions, which are required starting at age 72. 

In 1998, Congress created a new way to save for retirement. Named after the late Senate Finance Committee chair William Roth, these accounts flip the tax benefits. Contributions are made with after-tax dollars, but distributions are tax-free. And there are no mandatory distributions at age 72. At first, Congress limited the ability to convert from a traditional IRA to a Roth to those making $100,000 annually or less. But since 2010, anyone can convert. Congress even created Roth 401(k)s. 

The federal government pays a high price for all of these savings incentives, more than $250 billion in 2019 and in excess of $1.5 trillion from 2019 to 2023. But the real long-term cost is far higher.

One big reason is Roth accounts, which were created in large part as a budget accounting trick. When savers convert a traditional account to a Roth, they have to pay tax on the transfer since it is treated like any other distribution. But after that, they can withdraw investment income from their Roth account tax-free. And while you can only contribute a limited amount directly to a Roth in any given year, you can convert as much as you want from a traditional account to a Roth.

Because Congress’s budget rules focus on the 10-year cost of legislation, Roths allow lawmakers to game the system. During the 10-year budget window, all those conversions count as expected tax revenue. But lawmakers can ignore the cost of trillions of dollars of lost revenue down the road.

This year, the House and Senate each have bills that aim to help Americans increase their retirement savings, including special assistance for low-income workers who encounter the most obstacles to saving. That’s important since today’s retirement tax system disproportionately favors the rich.

Both the Senate Finance Committee’s Enhancing American Retirement Now (EARN) Act and the House-passed Securing a Strong Retirement Act of 2022, or Secure 2.0, would improve the Retirement Savings Contributions Credit, or saver’s credit, and make some other changes to make retirement savings easier for some low- and moderate-income workers. These provisions are modest, and would benefit those who already have extra income to save. 

And with both bills, lawmakers play the same budget game, offsetting the 10-year cost of expanded retirement tax breaks with provisions that encourage savers to favor Roths over traditional IRAs. 

But the real winners from Roth conversions are the Wall Street firms that manage the money as well as those who need little government incentive to save. They already have discretionary income, not only to save and invest but also to pay taxes upfront. That includes the super-wealthy who continue to use Roths to shelter their future accumulation of wealth from taxes. That’s not a productive use of tax expenditures. 

Even a little change would have been a good start.

Remember the House-passed Build Back Better Act? It had a provision to limit conversions to single filers making $400,000 or less or joint filers making no more than $450,000. That would have been a little more fiscally responsible while allowing for more tax subsidies for those who need them. The idea died in the Senate. 

If Congress does pass a retirement savings bill this month, it is pretty certain no new income limit on Roth conversions will magically appear like the Ghost of Christmas Present. 

Not that I’m saying Congress is irredeemable. But it sure makes strange choices. 

Congress Could Save the Day for More Savers (Not Just The Wealthy Ones)

The Tax Hound, publishing once a month, helps make sense of tax policy for those outside the tax world by connecting tax issues to everyday concerns. Have a question or an idea? Send Renu an email.

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