Tax Reform I: Expand the IRA

As Congress turns its attention to tax reform, one desirable change would be to expand the availability of IRA accounts to more taxpayers, with higher limits, and for purposes other than retirement. I’ll follow up with more tax reform recommendations in later posts, and apologize for making my first suggestion a somewhat technical one.

Current tax law places a double tax on saving, unless the saving takes place within certain specifically created accounts, like IRAs, 401(k)s, 403(b)s, and other plans offered by (some) employers. The reason most saving is double-taxed is that saving comes out of income that is subject to the income tax, and then when interest, dividend, and capital gains income is earned off that saved income, it is taxed again. The big advantage those specifically created accounts provide is that they tax savings only once. For the most part, no income tax is paid on the saving when it goes into the account, and then income tax is paid on the money that is taken out. Roth IRAs and other Roth accounts tax the money that goes in but money can be withdrawn without paying taxes again. These accounts eliminate the double tax on saving, which is both fair and creates more of an incentive to save rather than consume income.

Because of the perks that come with their jobs, upper-income people typically have many options for participating in these savings plans and eliminating the double tax on saving. That’s not so true of lower-income people. They can choose to open their own IRA accounts, but there are contribution limits that constrain how much money they can put in. And, except for the Roth accounts, contributors face financial penalties if they withdraw money from their accounts before they reach age 62, which further discourages contributions.

The double tax on saving is unfair and inefficient. One suggestion for mitigating it is to expand the availability of IRA accounts, and allow withdrawals at any time without penalty. Money people are saving to buy a house or car or a vacation would be treated the same as money people are saving for retirement. By default, I would make them Roth accounts, but allow the option to set up accounts like traditional IRAs.

My suggestion is to allow people to contribute up to 20% of their incomes into Roth Savings Accounts (RSAs). That income would be taxed as ordinary income when it goes into the account, but no tax would be due on withdrawals. I favor this, especially for low-income people, so that withdrawing money from savings does not make them liable for additional taxes.

This proposal is not as radical as it will seem to some readers. Many employers already have established Roth 401(k) or Roth 403(b) plans for their employees with contribution limits that exceed $20,000 a year. My proposal would just extend (with minor changes) this same option to everyone. I’d make the limit a percentage of income rather than a fixed dollar amount, and allow people to choose to save with any institution that offers accounts rather than just the ones their employers have chosen. Why should some people (who mostly are high-income people) have this option while others do not, simply because of where they work?

Just a personal note: My employer does offer employees the option of contributing to Roth 403(b) accounts, and I do. My post is not sour grapes, wishing I had something available to others. I’m wishing everyone had the same savings opportunity I have.