Sunday, February 8, 2004
 

Getting started

Retirement proposals resurface

By Jeff Brown
Knight Ridder Newspapers

President Bush wants to make investing easier and more profitable. Great! But it has a pie-in-the-sky feel to it. So how do we hedge our bets in case it never happens? Bush's 2005 budget includes proposals to convert today's confusing array of IRAs, 401(k)s and other investment plans for retirement and college into accounts that are simpler and more generous. He would allow us to put more money into tax-free plans similar to today's Roth IRAs, permitting anyone to contribute regardless of income and allowing investors to get at their money earlier and more easily than they can now. Bush touted a similar idea with great fanfare about a year ago, then quickly dropped it to focus on his higher priority, tax cuts. That could happen again as he tries to make his previous cuts permanent. In fact, this time it's fair to wonder whether the real goal is to propose a tax-free benefit that deficit-conscious Democrats will feel obligated to oppose, giving the president a campaign issue. The proposal would create Retirement Savings Accounts (RSAs) that would work much like today's Roths. Investors could put in up to $5,000 per year, compared with $3,000 for Roths ($3,500 if you're older than 50). As with Roths, there would be no tax deduction on contributions, but also no tax on withdrawals. Existing Individual Retirement Accounts (IRAs) could be converted to RSAs, though income tax would have to be paid on any money, such as investment profits, that had not been taxed before. While today's Roths are available only to people below certain income limits, anyone could have an RSA and convert older IRAs into the new accounts. In addition, investors could take money out without penalty or taxes after turning 58, compared with the 59-1/2 in today's IRAs. Bush also proposes Lifetime Savings Accounts (LSAs) that would allow investors to make tax-free withdrawals at any time, for any purpose, without penalty. These, too, would have a $5,000 annual limit on contributions. There'd be no deduction on contributions and no tax on withdrawals, nor any restriction on who could contribute. Investors could convert all sorts of tax-free accounts into LSAs, including Coverdell Education Savings Accounts and Section 529 college savings plans. Next, he's proposed an Employer Retirement Savings Account (ERSA) to replace a raft of existing plans such as 401(k)s, 403(b)s, Governmental 457s and so forth. The new ERSA would work about like a 401(k). Finally, there'd be an Individual Development Account for single people with annual incomes below $20,000 and married couples with incomes below $40,000. It would provide matching contributions, funded by the government, for individuals who saved up to $500 per year. As I mentioned, there are lots of hurdles between here and enactment.

Expanding tax-free investment programs will inevitably deprive the government of some tax revenue, possibly a lot of it. That may be hard to sell to a Congress that's wrestling with ever-growing budget deficits. Also, some of the proposals would chiefly benefit the affluent. Increasing the annual contribution limit to $5,000 and adding a new tax-free program with a $5,000 annual limit won't mean much to people who have nowhere near that much to save. In fact, very few people make maximum annual contributions to today's IRAs and 401(k)s. Clearly, the Individual Development Accounts are proposed to blunt the complaint that all this is for the rich. So, who knows? These proposals could be enacted. What, then, should investors do to prepare for the possibility? Save, save and then save some more. That's always a good practice — and especially so now. It would be great to have an extra $10,000 at hand if Bush's proposals are enacted. But if you have a 401(k) or similar plan at work, continue to make fully funding it your top priority. Even though the new programs would offer tax-free investing while gains in the 401(k) are taxed on withdrawal, it pays to get the upfront tax deduction provided on 401(k) contributions. As proposed, the new accounts won't have that. At a minimum, put all you can into a 401(k) or similar plan to get every dollar in matching contributions offered by your boss. If, after fully funding your 401(k), you have other money to invest, go for the Roth if you qualify. This should serve you well if the president's proposals are not enacted. If they are, it will be easy to convert your Roth to an RSA. Traditional IRAs continue to be appealing primarily for people who are eligible for tax deductions on contributions. Otherwise, it's hard to justify tying money up in an IRA until you're 59-‡ and paying income tax on withdrawals of up to 35 percent. Not when the same investment in a taxable account would be more accessible and possibly subject to the capital-gains tax of only 15 percent. Section 529 and Coverdell plans, both offering tax-free investing for college, are still attractive. They, too, could be converted to the new Lifetime Savings Account. And what if you have more money to invest after doing all these things? Get an ordinary taxable account. In these, capital gains and dividends are now taxed at only 15 percent. But until the situation with the president's proposals is clearer, think carefully before tying money up for the long term — in bank certificates of deposit, bonds or annuities, for instance. It will be maddening to have thousands locked up in a taxable investment if you get a chance sometime this year to put it into a new account where the profits will be tax-free.