Scrambling America's Nest Eggs

Tax breaks to encourage savings. Most economists love the idea, and Republicans have made them a central plank of their economic policies since the 1980s. Now, George W. Bush is pushing a sweeping set of proposals that could fundamentally alter the way almost all Americans save and plan for retirement. If adopted, they would also exempt most future investment profits from income taxes. Here's what he proposes and how it could play out:

What is Bush's plan to boost and simplify savings?

The proposal takes a welter of tax-favored individual savings programs and boils them down to two. To replace Individual Retirement Accounts, a worker could put up to $7,500 a year ($15,000 for a couple) into a retirement savings account (RSA) that can't be touched until age 59. For college, medical, emergency, or other savings, each person could put $7,500 a year into a lifetime savings account (LSA), which can be tapped at any time. Neither account offers an up-front tax deduction for contributions. But a saver would never pay taxes on earnings from either account.

For workers, the Bush plan would sweep all 401(k)-style retirement plans into one new account. The employer retirement savings account (ERSA) would resemble today's 401(k): Workers could save $12,000 a year in pretax dollars, as they can now, and pay taxes when withdrawing funds in retirement.

Will these tax carrots increase savings?

The Administration thinks so. Officials say they've addressed several major barriers that have limited the appeal of tax-favored savings plans in the past. Families may be more willing to commit funds to LSAs because they can easily tap them in a crisis. The new ERSAs will make 401(k)-style plans cheaper and more attractive for employers. And raising IRA limits from $3,000 to $7,500 will encourage financial institutions to promote the new accounts. "We have to eliminate disincentives and create a culture of people saving for their futures," says Pamela F. Olson, Assistant Treasury Secretary for tax policy.

Yet there's no evidence that tax breaks inevitably (or automatically) lead to lasting changes in savings behavior. In the 20 years since 401(k)s were invented, for example, personal saving has declined from 10% of income to less than 4%. Financial incentives for saving have had less impact than social forces--such as easy credit--and economic trends.

Initially, most of the new tax breaks would go to households that convert existing accounts to LSAs--moving money from one pocket to another without adding to overall savings. In the longer run, exempting investment income from taxes should make saving more appealing for higher-income families with extra cash. But creating new saving habits means breaking spending habits--a hard job for most Americans.

Will Bush's plans help baby boomers prepare for retirement?

The new RSAs are targeted, Olson says, at the 50% of workers--mostly middle- to lower-income--who don't have pensions. But those families already get a big tax break: They can take an immediate deduction for every dollar they put into an IRA. Replacing that instant reward with a deferred tax break--money withdrawn from RSAs in the future wouldn't be taxed--isn't likely, say critics, to reduce the long slide in IRA participation, from 16.6% of taxpayers in 1986 to 2.7% in 2000.

The other force that nurtures nest eggs is employer pressure. Workers are 2 1/2 times more likely to save via employer-sponsored plans, such as 401(k)s, than they are on their own. The Bush plan simplifies 401(k)s but also makes it easier for companies, especially small ones, to bypass pensions altogether.

Today, small-business owners can't get major tax breaks for their retirement without creating a company savings plan and encouraging all workers to participate. Under Bush's system, entrepreneurs and their spouses could save $30,000 a year without having to provide a pension plan for employees. "This could be the beginning of the dismantling of employer-sponsored retirement," warns Brian Graff, executive director of the American Society of Pension Actuaries.

Corporate America isn't likely to ditch pensions. But the new ERSAs will eliminate some of the rules that linked caps on executives' contributions to the participation rates of lower-paid workers. The result: less incentive to promote ERSAs to the rank and file.

What will be the fiscal impact of the President's plan?

At first, the Treasury Dept. expects to gain revenues from IRA owners who choose to switch to RSAs. To make the switch, an IRA holder must pay tax on any past deductible contributions and untaxed earnings. Even if less than 5% of the $2 trillion in IRA assets are moved, Treasury projects tax payments of $18.7 billion--a nice cushion for Bush's budget through 2006.

Then the picture could change: As tax-free accounts come to dominate the retirement scene, Treasury's collections on investment income will plunge. In two decades, economists at the Urban-Brookings Tax Policy Center estimate, more than half of households' financial assets would be sheltered from taxes--costing the Treasury more than the $50 billion it expects to lose each year from exempting corporate dividends from tax. That's a steep hurdle for these proposals to overcome.

By Mike McNamee in Washington

    Before it's here, it's on the Bloomberg Terminal.