Bush Budget Bomb About to Blow

Issue Brief on the 2010 Roth IRA Conversion Giveaway

A tax loophole that will allow high-income earners to invest in Roth IRAs beginning in January 2010 is a shortsighted scheme that is fiscally irresponsible and economically backward, write Isha Vij and Michael Linden.

Sandy Gay, 2nd grade teacher at Princeton Primary School, helps a student in Princeton, WV. Gay is among the more 19,000 teachers and school officials who rely on 401(k)-style accounts for their retirement. (AP/Jon C. Hancock)
Sandy Gay, 2nd grade teacher at Princeton Primary School, helps a student in Princeton, WV. Gay is among the more 19,000 teachers and school officials who rely on 401(k)-style accounts for their retirement. (AP/Jon C. Hancock)

A tax loophole designed by the Bush administration will open up beginning in January 2010 that will allow high-income earners to invest in Roth IRAs for the first time. Roth IRAs are retirement accounts that have no exclusion or deduction for contributions, but that are exempt from tax on any of the earnings that the accounts generate, and have no tax imposed on them when funds are withdrawn for retirement.

Expanding eligibility to wealthy taxpayers will create a temporary increase in revenue for the government as people pay an upfront tax for the privilege of converting their savings from traditional IRAs to Roth IRAs. But it will ultimately result in a long run loss since the earnings in those accounts are tax-free.

This policy is a shortsighted scheme that will reduce the budget deficit in the next couple of years at the expense of exacerbating it for decades to come. This is both fiscally irresponsible and also economically backward, since we currently need deficit spending to help us escape from the grips of the Great Recession. This loophole was deliberately designed—like so many other Bush administration smoke-and-mirrors budgetary gimmicks—to hide the long-term costs of a tax cut for the wealthy. It is a reckless approach to budgeting, and it is a regressive tax giveaway that solely benefits the better-off.

What are Individual Retirement Accounts?

An Individual Retirement Account is a personal investment account that American taxpayers use to set aside money for their retirement. The basic idea behind the creation of the IRA was to encourage people to save money for their retirement by offering tax advantages for planning ahead. People can invest money into an IRA—or multiple IRAs—which will accrue earnings, all of which can be used to fund your retirement years. The earlier you start contributing to an IRA, the more retirement income you will presumably have as a retiree. There are several different account options to choose from, but the most popular are the traditional IRAs and Roth IRAs. The two share some similar qualities, but there are different conditions and eligibility requirements for each—and most importantly—the tax implications vary greatly between them.

Traditional IRA

Anyone under the age of 70 and six months with taxable income is eligible to contribute to a traditional IRA. Traditional IRAs are financed by pre-tax contributions, which, for people younger than 50 years old, can total an annual investment up to 100 percent of earned income or $5,000, whichever is less. People 50 and older can contribute an additional $1,000 on top of the $5,000 limit—or 100 percent of earned income—whichever is less. This is to help people approaching retirement “catch up” and reach their retirement savings goals.

Earnings that are contributed to traditional IRAs are untaxed—the contributions are deductable—which enables many people to contribute more to their retirement account than they otherwise would. This can result in a higher savings balance than if they had invested in an alternative savings account with after tax dollars. There are some limits to the deductibility of IRA contributions, however. People who are part of an employer-sponsored retirement plan may not be able to fully deduct their contributions or may be unable to deduct them entirely, depending on their income.

Account holders are able to withdraw funds from their IRAs at any time, but they may face penalties and fees if they do so before a certain age. With a traditional IRA, funds withdrawn after the owner reaches 59 and six months are penalty-free, and owners must begin taking calculated minimum withdrawals (distributions) after age 70. Because the contributions into the account were tax-free, the withdrawals are not.

Roth vs. traditional IRAs

Roth IRAs have a completely different set of conditions and payout policies than traditional IRAs. The most important difference between a Roth IRA and a traditional IRA is that contributions to Roth IRAs are not tax deductible, but the accumulated investment earnings are tax-free. In other words, the earnings that go into the account are taxed, but the money that comes out is not, regardless of how large the return on the investment.

Another difference between Roth and traditional IRAs is that Roth IRAs have far more flexibility in terms of withdrawals. Roth IRA holders don’t have to start taking out minimum distributions upon reaching a certain age. They can indefinitely leave their money in the accounts. In fact, unused Roth IRAs can be passed on to heirs. A nonspouse beneficiary of an inherited Roth IRA can then withdraw the money in that account and will pay no tax whatsoever on the income —though nonspouse beneficiaries do have to take minimum required distributions.

Unlike traditional IRAs, there are strict income eligibility limits that have prevented high-income earners from investing in a Roth IRA. Only individuals with taxable compensation and modified adjusted gross income of under $120,000 could contribute fully or partially to a Roth IRA in 2009, depending on their actual income level. The AGI limit was $176,000 for married couples filing jointly. Roth IRAs are subject to the same annual contribution limits as traditional IRAs.

Since the funds in Roth accounts are composed of after tax contributions and withdrawals are tax-free, it essentially enables the investor to lock in their current tax rate and to avoid any tax at all on gains from the investments. And because Roth IRAs have no distribution requirements, they can be a very attractive vehicle for passing on completely tax-free wealth to beneficiaries. The law has, until now, prevented high-income earners from holding these tax-free savings accounts because it would allow them to pay far less in taxes than if they had invested their money in a traditional IRA.

One good gimmick deserves another

The income restrictions on Roth IRAs will effectively disappear starting in 2010. Everyone— regardless of income—will be able to convert a traditional IRA into a Roth IRA come January. This will allow wealthy investors to earn interest in a tax-free account with no restrictions on withdrawals. No household making less than $176,000 will benefit from this change, which amounts to about 97 percent of households.

The virtual elimination of income restrictions for Roth IRAs was passed nearly four years ago as part of much larger package of tax breaks for the wealthy. That package, the Tax Increase Prevention and Reconciliation Act of 2005, was itself related to earlier tax legislation, the Jobs and Growth Tax Relief Reconciliation Act. JGTRRA reduced tax rates on capital gains and dividends, but did so only through 2008. These tax cuts were made to seem temporary in order to make their long-term costs appear smaller. This tactic, called sun-setting, was an oft-used budgetary gimmick used to make expensive tax cuts appear less fiscally damaging. Yet President Bush urged Congress as 2008 approached to extend the lower tax rates on capital gains and dividends an additional two years—making those provisions permanent would have made clearer the deficit hole that was being dug for the country.

The federal budget deficit already exceeded 2.5 percent of GDP in 2005, however, and Congress wanted to find a way to offset some of the $50 billion it would cost to extend those tax cuts through 2010. They didn’t want to appear to be boosting the deficit. And allowing wealthy investors access to the benefits of the Roth IRA helped solve their problem.

When the change takes effect, individuals earning over $120,000 will be able to roll money from existing traditional IRAs into a Roth IRA. These wealthy investors will also be able to create a new traditional IRA and then immediately convert it to a Roth IRA, so even though they will still be unable to directly open a Roth IRA, this restriction will be meaningless in practice.

This change helped “pay” for extending the capital gains and dividends tax cut because investors will have to pay a one-time conversion tax when they convert from a traditional to a Roth IRA. This will produce increased tax revenues in 2010 and 2011 when the very wealthy rush to take advantage of the new legally sanctioned tax shelter.

Congress was able to count this two-year spike in revenues as a partial offset to the cost of extending a different set of tax breaks for the wealthy. Unfortunately, after the first few years, this provision will begin costing the federal government money since billions of investment dollars will be in tax-free retirement accounts when they would otherwise have been in taxable ones.

Congress essentially found a new budgetary gimmick to help pay for the consequences of the old budgetary gimmick instead of actually raising other taxes or reducing spending to help offset the cost of their policies. As Tax Policy Center’s Howard Gleckman has observed, “Congress financed a set of unaffordable tax breaks with another unaffordable tax break.”

Implications of the Roth IRA loophole

The 2010 Roth IRA conversion loophole will essentially create a tax shelter for the wealthy that will allow them to lock in current tax rates and escape any future tax on their gains. In the short run, the Treasury will benefit too, since the tax that people will pay on the conversion translates into immediate revenue. But after 2015 the Treasury will face a huge annual loss in foregone revenue from the taxes that would have been paid on withdrawals from the Traditional IRAs that were converted to Roth IRAs. This is a shortsighted scheme that will reduce our fiscal deficit this year at the expense of exacerbating it later.

Some economic analysts have calculated that this loss will amount to about $100 billion by midcentury. There are even some financial planners who argue that the costs of this provision will vastly exceed our present expectations since the wealthy may rush to lock in current tax rates, believing that future tax rates will be higher.

Not only is this giveaway a shortsighted approach for long-term fiscal planning; it could also have some negative economic ramifications in the short term. During a nascent economic recovery, the government should focus on keeping funds in the hands of consumers and investors now. The 2010 Roth IRA conversion loophole will do just the opposite: create an incentive for people to pay taxes now and forego the future revenues that are necessary for fiscal sustainability.

Allowing better-off investors to convert their traditional IRAs into Roth IRAs is also a regressive policy that will reward the wealthiest among us and provide no benefit to the middle class or low-income earners. This simply doesn’t add up at a time when we are facing a serious long-term fiscal challenge.

Allowing these conversions to go forward will have several negative consequences and offer no overall benefit. Future deficits will rise even though current tax collections will get a boost. Very wealthy people will be allowed to accrue earnings completely tax-free, while the middle class will derive no additional benefit at all. This policy is a relic of a time when budget gimmicks to hide true costs were routine, tax cuts for the wealthy were the highest priority, and no regard was given for long-term fiscal impacts. Allowing this policy to go forward will be detrimental to building a sustainable budget and will likely make the middle class vulnerable to higher taxes in the future, while providing a tax refuge for the wealthy. Congress should defuse this budget bomb before it goes off in January.

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Michael Linden

Managing Director, Economic Policy