The Proposed Overhaul of Retirement Savings Plans

Bob Marshalla, 2/24/2003

Recently, the Bush administration has proposed major changes in the structure of tax-advantaged retirement plans. Their proposal would essentially replace traditional and Roth IRA’s, as well as an alphabet soup of employer plans (401(k)’s, 403(b)’s, 457’s, and others) with three new types of plans. If enacted, this proposal would greatly simply the current retirement plan maze, as well as substantially expand the contribution limits and range of people eligible.  For your information and entertainment, I am providing a summary of the key features here, but keep in mind that this is currently only a proposal. It is possible that none of it, or a much altered version, will ultimately be enacted by the Congress in the coming months.

Two new individual plans would take the place of the current traditional and Roth IRA’s.  Both of these new plans would operate much like Roth IRA’s do now: They would be funded by individuals with after tax dollars, but all subsequent investment earnings – capital gains, dividends, interest – as well as the principal, would be tax free upon withdrawal (as opposed to “tax-deferred” as is the case for the traditional IRA). The other key aspects of the proposals are that they would be equally available to everyone, regardless of income level, and that the contribution limits would be generous relative to current amounts allowed for personal IRA’s.

Lifetime Savings Accounts

The Lifetime Savings Accounts would be a savings vehicle that all Americans could use to save for any financial goal including, but not limited to, education, real estate, and medical expenses. With a contribution limit of $7,500 per year for each individual (i.e., $15,000 for a married couple), savers could make withdrawals from the account at ANY time for ANY purpose with no penalties. Earnings on the withdrawals would be tax-free, similar to Roth IRAs, although withdrawn money could not be put back into the account later, so the continued tax advantage of the investments would be lost.

Retirement Savings Accounts

In an attempt to simplify the maze of current Individual Retirement Accounts (IRAs), Retirement Savings Accounts would act like the current Roth IRA by featuring tax-free growth with no up-front tax deduction. The annual contribution limit would be $7,500 per person (contribution limit is now $3,000). Savers could take tax-free withdrawals starting at age 58. Existing IRA’s could continue to be held as before, but new contributions to traditional IRAs would cease.

A very significant feature is that the plan would allow for the conversion of existing IRA’s into the new Retirement Savings Accounts, dollar for dollar. In my opinion, this is the most under-publicized benefit of the whole package. Although the conversion would trigger current taxes on the amount converted, the individual could end up with a substantially greater value of assets in tax advantaged savings, and if held for a long time, a potentially much greater future wealth.

Employer Retirement Savings Accounts

Currently, employers use an alphabet soup of retirement plans. The new Employer Retirement Savings Accounts (ERSAs) would replace 401(k) plans, 403(b) plans, SIMPLE 401(k) plans, governmental 457 plans, Salary Reductions Simplified Employee Pension plans (SARSEPs), and SIMPLE IRAs. The new ERSA would be similar to the current 401(k) plan but with a more simplified set of rules. The contribution limit will be set at $12,000 per year initially, increasing to $15,000 by 2006.

A great additional feature of the plan is that contributions to the employer account would not affect the amount the person could make to the new individual plans.

Conclusion

From the individual investor’s point of view, the proposal on the table is quite attractive. (I’m not commenting on the potential fiscal effects on the overall budget, or the social equity implications. The former is a much larger issue that must consider much more than retirement plans, and the latter is based on personal social philosophies.) The benefits include:

(1)   Simplification of the incredibly arcane current system.

(2)   Expansion of contribution limits and eligibility. Individuals would be able to contribute up to $15,000 per year to the individual accounts (or $30,000 per year for a married couple), regardless of income, age or coverage by employer plans.

(3)   The ability to increase the value of tax advantaged savings via conversion of current tax-deferred plans to the new tax-exempt retirement accounts.

It may be a bit premature to worry about the details of these proposals, since there is no telling what, if anything, will actually be enacted. But the changes on the table are pretty significant, so it is interesting to consider what might be in the works.