The Obama administration has revealed that the budget proposal to be published later this week will include a $3 million cap on retirement accounts.
Details concerning the cap were not available, so it isn’t known whether it will function only to prevent additional contributions when account values reach this limit or if there will be some other mechanism instead or in addition.
The administration pointed out that a $3 million retirement account is enough to fund a $205,000 annuity. The implicit suggestion is that retirement savings above this level should not qualify for a federal tax subsidy.
Mitt Romney may have played an unintentional role in provoking this proposal. Financial disclosures during his presidential campaign indicated the value of his IRA may have reached as high as $100 million or more. The disparity between this figure and annual contribution limits led to speculation that questionable valuations may have played a role in producing such a large account. In particular, it has been suggested that his retirement account may have purchased Bain investments at low values, in anticipation of spectacular increases.
The big picture
The proposal may be intended to address a larger issue than questionable valuations. The dirty little secret of federal tax benefits for retirement accounts, which represent one of the largest tax expenditures, is that these benefits are heavily weighted toward individuals whose income is more than sufficient to enable them to set aside adequate retirement savings without the benefit of a federal subsidy. And while this point is not widely understood, the overall effect of federal tax treatment of retirement savings for high-income individuals is to provide them with a negative rate of tax on their investment earnings. You read that correctly: the effective tax rate on investment income produced by these accounts is actually negative.
Impossible? To see why, you have to understand that a Roth account (which allows a zero rate of tax on investment income) can be equivalent to a traditional account. This equivalence, which I call the parity principle, requires various assumptions, including a constant rate of income tax. If your tax rate in retirement is lower than in the years when you contribute to a traditional account, the account can perform better than a Roth. And if it’s doing better than an account with a zero tax rate, it has to have an effective rate that’s negative.
There are sound policy reasons for imposing some kind of limit on the federal tax subsidy provided to retirement accounts of relatively wealthy individuals. Yet there’s a tradeoff in attempting to do so. Tax-favored retirement savings for higher-income individuals act as a carrot for small business to provide retirement benefits to rank and file workers. Many small businesses are willing to incur the costs of maintaining retirement plans that cover most or all of their workers only because the plans provide generous benefits to owners and key employees. Some of these businesses may reduce their commitment to retirement plans, or terminate them altogether, if benefits to the intended beneficiaries (the high-income workers) are capped.
- Policymakers may have considered this possibility but decided the tradeoff makes sense anyway. While many millions of lower-income individuals have retirement accounts, most of these accounts are too small to make a significant difference in the individual’s financial security in retirement, and many of them are withdrawn rather than rolled over when workers change jobs.
Seen this movie before
A previous initiative with a similar motivation was signed into law, believe it or not, by President Reagan. The main provision was a 15% surtax on “excess distributions” from qualified retirement plans. The provision was a boon for tax planners who wrote articles deriding it as a “success tax” and suggesting ways to plan around it. Laws signed by President Clinton first suspended and then repealed this tax (former section 4980A of the Internal Revenue Code).