The Cato Institute
WASHINGTON -- Turning Roth IRAs into Universal Savings Accounts
by Chris Edwards and Ernest Christian
In recent years, Congress has reduced taxation on personal savings by cutting the capital gains tax rate and liberalizing rules on pensions and savings vehicles. But large tax barriers to saving remain, including restrictive rules on eligibility, contributions, and withdrawals for savings vehicles such as the Roth Individual Retirement Account.
Roth IRAs allow eligible individuals to make limited deposits from after-tax income into accounts with tax-free earnings and withdrawals. Roth IRAs were created in 1997 and modestly liberalized in 2001. They should be expanded further to create "universal savings accounts," or USAs, that all families could use for all types of savings.
Indeed, the Bush administration is considering options to expand personal savings accounts to encourage more families to save, simplify the tax code, and boost U.S. economic growth.
Roth IRAs have become an important family savings tool, supported widely by financial planning experts. Annual contributions of up to $3,000 (rising to $5,000 by 2008 under current law) from after-tax earnings may be made to the accounts.
Because income used for contributions has already been taxed, no tax is imposed on qualified distributions from Roth IRAs. That equalizes the tax treatment of saving and consumption, because after-tax income used for consumption does not face further taxation either. Roth IRAs remove the income tax bias that dissuades Americans from setting aside enough money for the future.
Like Roth IRAs, regular IRAs and 401(k)s eliminate the double taxation of savings. Those vehicles allow an up-front deduction for contributions, but subject withdrawals to tax. However, unlike those accounts, Roth IRAs create little federal revenue loss in the near term, and they are less complicated. For example, Roth IRAs do not have the minimum distribution rules that kick in at age 70-and-a-half that regular IRAs do.
However, Roth IRAs have important restrictions that reduce their attractiveness, including low contribution limits and tight restrictions on distributions. For earnings to be free of income tax and a 10 percent penalty, accounts must be held for five years and distributions may not take place before age 59-and-a-half subject to a few exceptions such as first-time home purchase. Those restrictions discourage savings by reducing liquidity and locking up investment earnings for decades.
Millions of families choose not to use the Roth IRA or other savings vehicles at all because of such restrictions and because of confusion regarding the complex limitations (the IRS taxpayer guide to IRA rules is 90 pages long).
Eleven percent of U.S. households hold a Roth IRA with a median account balance of $6,000. The participation rate and amounts saved in Roth IRAs are very small compared with the potential, because of the restrictions on eligibility, contributions, and withdrawals.
However, the Roth IRA is based on the sound economic principle that the returns to saving should be taxed only once, not twice as is usually the case under the income tax.
On this sound footing, the Roth IRA is a ready-made vehicle for Congress to expand into USAs. By turning Roth IRAs into USAs, all families would have a simple and flexible method to structure nearly all of their savings. USAs would greatly simplify financial planning and help families build economic security free from the risks of pensions tied to companies and the insolvent Social Security system.
Congress could convert Roth IRAs into USAs by expanding eligibility to all Americans, liberalizing contribution limits, and allowing families to save for all purposes (not just retirement) by repealing current distribution restrictions.
Roth IRA eligibility is limited to taxpayers with incomes of less than $110,000 (single) and $160,000 (married), with those near the limits required to calculate a phase-out of their contribution. Such limits cause confusion since they differ from limits on other savings plans. All eligibility rules should be repealed to simplify the tax code, increase fairness, and maximize the nation's personal savings rate.
Next, current contribution limits on Roth IRAs should be repealed. Annual contributions to USAs would be limited to 50 percent of taxable income or $10,000, whichever is greater. Some lawmakers oppose expanding contribution limits on regular IRAs and 401(k)s because that would allow taxpayers to reduce current taxes too much and create a federal revenue loss.
But with USAs, deposits come from earnings after taxes are already paid, and near-term revenue losses would be minimal. Since modest-income families have low or zero taxable income, the USA would have an alternate cap of $10,000 per year.
Contributions to USAs would have to be in cash, not stocks or bonds. That would ensure that current savers would have to sell securities and pay tax before they could deposit existing funds into a USA.
The third reform is to repeal rules imposing taxes and a 10 percent penalty on earnings if distributions are made prior to age 59-and-a-half or before the end of five years. Instead, saving in USAs would be for all purposes, so families would be able to withdraw their funds tax-free anytime after a three-year holding period. Families could use the accounts to save for many planned and unplanned expenses, such as retirement, education, unemployment, medical costs, funeral expenses, moving and other needs.
If Roth IRAs were restructured as USAs, they would emerge as a popular and economically powerful financial tool that would foster upward mobility and promote savings for families who do not save enough now. Young families would be able to accumulate wealth and build financial security like never before because current limitations, taxes and penalties would be removed.
USAs would work like a brokerage account in which savings could be invested in bank deposits, bonds, or stocks. Interest, dividends, and capital gains within the accounts would be tax-free. USAs would hugely simplify financial planning because there would be no need to pay tax on account earnings, and no need to learn the multiplicity of rules that relate to items such as capital gains or special-purpose accounts, such as education IRAs.
The economy will be faced with severe strains as federal spending on Social Security and other entitlements will explode in cost and impose a huge burden on future taxpayers unless reformed. The solution is increased personal savings to build the economy and allow individuals to pay for more of their own future consumption. Removing tax barriers to saving through USAs could greatly boost personal savings.
USAs would complement Social Security reforms that would set up individual accounts funded by the current payroll tax. Social Security private accounts would increase personal financial security and raise retirement income for those opting for the new system. USA accounts would serve as a voluntary add-on to Social Security private accounts, but could be used for family expenses other than just retirement.
All Americans would gain as USAs reduced the punitive taxation of savings, simplified family finances, and generated more investment capital to boost the economy.
(Chris Edwards is director of fiscal policy at the Cato Institute, and Ernest Christian is chief legal counsel for the Center for Strategic Tax Reform.)
The Nixon Center/The National Interest
(The Nixon Center is a public policy institution that is a substantively and programmatically independent division of The Richard Nixon Library & Birthplace Foundation in Yorba Linda, Calif. The National Interest magazine is published quarterly by The National Interest, Inc., a non-profit partnership of Hollinger International, Inc. and The Nixon Center.)
WASHINGTON -- The Realist: winning the fight without losing the war (From In The National Interest)
By Dimitri K. Simes
The first issue is what to do about Iraq, specifically Saddam Hussein. In my view he has to go. I think that he will make plenty of blunders -- if we play our cards right -- to provide a plausible pretext that will allow the United States to remove him. With a modicum of creative diplomacy and some humility in presenting our evidence, I think we can succeed with minimal necessary international support.
Why does he need to be removed? I believe that Saddam is a special case. We are still technically at war with him. We have evidence that he tried to assassinate former President George Bush. It is quite clear that we are not able to reach any kind of modus vivendi with him.
If this administration decided to make a deal with Saddam, something along the lines of "we leave him alone if he leaves us alone," coupled with more perhaps more intrusive inspections -- but essentially if we agree to allow him to be just another Middle East tyrant, that is not going to work.
It is not going to be accepted by the American body politic. In the practice of international relations, when you deal with a serious adversary you either try to cut a deal or you crush him. I don't see as us prepared as a country, not simply this administration, to make a deal with Saddam. That means he has to go.
The second question concerns our goals. Here I am a little uncomfortable with the direction of the discussion -- how the removal of Saddam is the first stage in the grand reshaping of the Middle East according to American specifications.
This is not because I don't prefer democracy to tyranny -- I voted for democracy with my feet. However, we have to be concerned about winning a very important fight, but losing an even more important war. And that raises a fundamental question in my mind.
Former Russian Prime Minister Yevgeny Primakov who is also, among other things, an experienced Middle Eastern expert, drew a parallel with the Soviet experience. He said that in his view the most unfortunate thing that happened to Soviet foreign policy was the American defeat in Vietnam coupled with the Soviet victory in Angola. It gave the Soviets an impression of invincibility -- the belief that they could walk on water, at almost no cost. And we all know what followed.
I do not believe in simplistic comparisons. It is obvious the United States has incomparably greater resources than the Soviet Union in the late 1970s and a much broader reach not only militarily but also economically and culturally than the Soviet Union at that time. But I am worried that we might learn the wrong strategic lessons from a likely tactical success.
I thought that our campaign in Afghanistan was a clear case. Following Sept. 11, we had to go -- we had no choice. We engaged in a military campaign in Afghanistan because the Taliban, by refusing to turn over Osama bin Laden and dismantle al Qaida, posed a direct threat to the security of the United States.
I think Iraq is a more complicated matter. On balance, I do think that we need to remove Saddam and decapitate his regime, and this will require the use of force. But I am concerned when people want to use a war in Iraq as a tool to achieve larger goals beyond removing the present, immediate danger.
Why is it not preferable, for example, to foment a coup d'etat, where Saddam might be removed, in one way or another? A new group of generals could rise to power as the ruling junta, allow unfettered inspections, and end any threat posed by the Iraqi WMD program.
That would be, in my view, the neatest solution. I don't know if it is feasible or not, but somehow I have a hunch that the U.S. president would not mind it if it were to occur. But if this was not possible, I would look for something closer to that model than a grand, ambitious scheme requiring a long American presence in Iraq.
In the name of promoting democracy in the Arab world, we would have to do things that would be looked at as rather nasty and would not be appreciated by the population we are supposedly trying to help. In the end, we may find ourselves on the receiving end of those very things that we want to avoid by taking out Saddam Hussein.
Finally, I want to say that no one expected when the Soviet Union collapsed, the next existential threat would arise from al Qaida and Saddam. I think that what we are dealing with today is a combination of Muslim extremism and a global backlash against the United States. If we behave in a manner that encourages this global backlash, I have no idea where the next threat will come from.
But I can only tell you when I go to Moscow, it is the younger, well educated people, many of whom studied in the United States, who are more anti-American than the older generation. I think that much of this can also be seen in China. So, it seems to me that we have to be quite careful in finding the right balance.
We need to remove Saddam from power and liquidate his weapons of mass destruction. We need to ensure that a post-Saddam regime is something better for the people of Iraq -- even if it is not a democracy. After all, the Soviet regime post-Stalin and the Chinese regime after Mao Zedong, even if not liberal democracies, were still immeasurably better.
Finally, we need to lay the foundation that will permit the United States to gracefully, but fairly quickly, exit post-war Iraq, under suitable international cover, if possible.
(Dimitri K. Simes is the president of The Nixon Center and the publisher of In the National Interest.)