IRAs and Other Savings Incentives: A Brief Overview
IRAs and Other Savings Incentives:
A Brief Overview
Jane G. Gravelle
Senior Specialist in Economic Policy
Government and Finance Division
Summary
Several types of savings are eligible for beneficial treatment under the individual
income tax, and Individual Retirement Accounts (IRAs) have received considerable
attention. Pension savings are actually more important in terms of revenue loss. There
are other investments that are treated favorably as well. The President has proposed in
a succession of budgets to significantly expand IRAs. Effects of these provisions on
savings are uncertain, and, despite dollar limits on contributions and income phase outs,
IRAs tend to benefit higher income individuals.
Description of Tax Treatment
Several types of investments are preferentially treated under the individual income
tax, including Individual Retirement Accounts (IRAs), pensions, capital gains, dividends,
owner occupied housing, and life insurance policy earnings.
There are two types of IRAs that have the effect of exempting investment earnings
from tax — the traditional (deductible) IRA and the Roth IRA. For the deductible IRA
(also called a front-loaded IRA), contributions are deducted when made and withdrawals
are taxed; this treatment is similar to the treatment of pensions. Eligibility for the
deductible IRA is phased out as income increases for individuals who are active
participants in employer pension plans. (Individuals above the income phase-out can
make non-deductible contributions, with earnings taxed when withdrawn, which allows
deferral, but not elimination, of taxes.) There are penalties for early withdrawal and
mandatory distribution requirements.
As described above, IRAs were treated the same way as pension plans, with
contributions deductible and withdrawals taxable. The Roth IRA (also called a back-
loaded IRA), was added as an option in 1997, when eligibility for both types of IRAs was
expanded. The tax treatment of this account is similar to that of a tax exempt bond:
earnings are simply not taxed. The earnings phase-outs are higher and treatment is, in
general, more generous than in the case of the deductible IRA. The annual deduction limit
for IRA contributions when expanded in 1997 was the lesser of $2,000 or 100% of
compensation; that limit was increased under the temporary provisions of the 2001 tax
cut and eventually made permanent at $5,000.
The 2001 act also introduced a tax credit for contributions by low income
individuals.
Favorable tax treatment of pensions, namely allowing the firm to deduct
contributions which are not included in employees income and exempting the earnings
of pension trusts as in the case of deductible IRAs, has been in place almost since the
inception of the tax law. Pensions fall into two types: defined benefit plans where
payments depend on earnings and years of service at retirement, and defined contribution
plans where payments depend on the amount accumulated in an account. Pensions are
subject to many rules and regulations designed to ensure that tax benefits do not accrue
to owners and highly compensated managers and that pension trusts are adequately funded
in the case of defined benefit plans. Of course to the extent that pension assets (or IRA
assets) are invested in corporate stock, tax is collected at the corporate level.
Tax benefits for pension plans are much more important in dollar terms than are tax
benefits for IRAs. For FY2009, according the latest Joint Committee on Taxation (JCT)
estimates, employer pensions resulted in a revenue loss of $120.4 billion, with plans for
self-employed individuals (called Keogh plans) costing $9.5 billion. IRAs resulted in a
loss of $18.5 billion.1 In the case of dividends, about half of the income is not subject to
tax because of tax preferred status.
There are other savings and investments that receive favorable treatment under the
individual income tax. Capital gains has historically been favorably treated, both through
lower tax rates, deferral (taxed only when realized), and forgiveness of tax if passed on
at death. Dividends are also now eligible for lower tax rates. Of course, earnings on
corporate stock are taxed under the corporate tax. Owner occupied housing is also
favorably treated because imputed rent is not included in income, and earnings on
investments in life insurance policies are deferred and, when passed on via death benefits,
exempt from tax. These tax benefits are significant as well. Lower rates for capital gains
and dividends are estimated by the JCT to lose $131.0 billion in FY2009, the failure to
tax gains at death $57.5 billion, and the deferral of gain for gifts $5.9 billion. While there
is not a separate estimate for excluding imputed rent, the value of deducting costs (even
though gross rent is not included in income) through itemized deductions is $85.2 billion
for mortgage interest and $14.2 billion for property taxes. The exemption of most capital
gains on homes is estimated to cost $30.1 billion. The value of deferral and forgiveness
of earnings on life insurance policies is $27.5 billion.
1 See Joint Committee on Taxation, Estimates of Federal Tax Expenditures for 2007-2011, JCS-
Recent Legislative Activity
IRAs were expanded by the 2001 tax bill, H.R. 1836, which was signed into law on
June 7, 2001. IRA limits increased to $3,000 in 2002, $4,000 in 2005 and $5,000 in 2008,
with indexation afterwards. Individual 50 and over had an extra $500 increase in 2002 and
will have a $1,000 increase in 2008. This bill also increased contribution limits for
pension plans, including 401(k) plans. Because of budget rules the tax cuts in this bill
were sunsetted in 2010, but the increased limit was made permanent by the Pension
Protection Act of 2006. The Pension Protection Act also allowed a rollover of IRA2
amounts to charity for those aged 70 and ½ without incurring tax effects. This provision
expired after 2007 but may be reinstated along with other extenders.
President Bush proposed in his FY2004 through FY2009 budget plans to eliminate
the deductible IRA form. His proposal would rename the Roth IRAs as Retirement
Savings Accounts (RSAs), and also allow Lifetime Savings Accounts (LSAs).3 The
contribution limits would be greatly increased (to $5,000 for each type of account under
the most recent proposal) and the income limits would be eliminated. Individuals could
roll over existing accounts into these new accounts, by paying tax on the rollovers, which
would increase revenue in the short run. The latest proposal is expected to initially gain
and then lose revenue, with loss in the tenth year of $.5 billion. In the long run, the
provision would cost much more. His proposal would also combine a variety of employer
savings accounts into a single account and simplify the rules designed to prevent
discrimination in favor of highly compensated employees. This proposal might form part
of an the President’s proposal for fundamental tax reform.
The Enron scandal and the slow recovery of the economy led to legislative proposals
regarding pensions in the 107th Congress that did not see completion and were notth
addressed in the 108 Congress. However, the Pension Protection Act of 2006 eventually
provided a variety of revisions and liberalizations of pension policy.
Issues
The original rationale for IRAs, first introduced in 1962, was to provide parity with
individuals covered by employer pensions. IRAs were made universally available in 1981,
with the primary rationale to encourage savings. Income limits that disallowed deductible
IRA coverage for most individuals were adopted as part of the base broadening in the
1986 Tax Reform Act; the 1997 legislation increased these limits and introduced Roth
IRAs. All but the very high income individuals and couples now have access to IRAs.
2 For itemizers, such contributions would be deductible, so the provision would not matter for
them. It would matter for non-itemizers, and also because there are some limits on itemizwed
deducitons for very large contributions relative to income. It could also affect the taxation of
social security benefits, which are determined by adjusted gross income.
3 See CRS Report RL32228, Proposed Savings Accounts: Economic and Budgetary Effects, by
Jane G. Gravelle and Maxim Shvedov, for an economic analysis of this proposal.
There has been considerable debate among economists about the effect of IRAs on
savings. Some statistical studies have found powerful savings effects of IRAs and have
argued that advertising of the tax benefit has caused people to save. Others have disputed
the evidence from those studies and argued that there is no historical evidence of an IRA
savings effect, and that economic theory does not support such an effect. Still others have
argued that IRAs are less important in increasing overall savings than the more generous
thrift savings accounts (e.g., 401(k) plans) provided through employers.
Although the dollar contribution ceilings and income limits on IRAs keep the
provision from providing benefits to very high income individuals, IRAs do generally
benefit well-off individuals who are more likely to save.4
The evidence that lower taxes on the return to investments increase savings in
general is mixed. Income and substitution effects, which in the one case lower and the
other case raise savings, may net out to little or no effect, and most simple evidence
suggests that savings rates do not change very much as tax rules change (although there
has been a trend downward in private savings rates).
4 See CRS Report RL30255, Individual Retirement Accounts (IRAs): Issues and Proposed
Expansion, by Thomas L. Hunger for Jane G. Gravelle for further discussion of savings and
distributional effects of IRAs.