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Rethinking retirement savings

President Bush’s proposal to eliminate dividend taxes has gotten most of the attention, but his sweeping plan to overhaul the nation’s retirement savings system, could have a far greater impact.
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President Bush’s much-touted proposal to eliminate dividend taxes has gotten most of the attention, but his sweeping plan to overhaul the nation’s retirement savings system, unveiled last week with little fanfare, could have a far greater impact.

THE SAVINGS PLAN, detailed this week in the administration’s $2.23 trillion budget proposal, would replace an alphabet soup of retirement, education and medical savings accounts with three new account types, vastly expanding the opportunity for tax-free savings and investment.

If approved by Congress — and that is a big if — the proposal would take a major step toward sheltering all investment income from taxes, experts said.

“Clearly there are people in the administration who believe the appropriate tax rate on capital income is zero,” said Eugene Steuerle, a senior fellow at the non-partisan Urban Institute. But proposing a direct tax exemption on capital income would have been far more costly in the near term and politically unpalatable.

Other analysts go further. Joseph Thorndike, director of the Tax History Project, said the new savings accounts could be a step toward abolishing the income tax entirely in favor of a new system of consumption taxes, a long-term goal of some conservatives. And he said the new accounts would have the added virtue for Bush of eliminating a stream of future tax revenues.

“It’s hard to avoid the prospect that Bush is comfortable with the idea of the federal government being starved for money down the road,” he said. “This is a small government agenda.”

At the heart of the Bush plan are proposed new Lifetime Savings Accounts that would allow individuals of any age or income to set aside up to $7,500 a year in after-tax income. Earnings — such as interest payments or capital gains — would accumulate tax-free and could be withdrawn at any time for any reason.

The plan also would establish separate Retirement Savings Accounts that could be funded at up to $7,500 a year for tax-free withdrawal after retirement.

With no upper income limits, the two accounts would allow an affluent married couple to set aside up to $30,000 a year in tax-free accounts — even more if additional accounts are established in children’s names.

Together the two plans would generate a net $33 billion in taxes over the next 10 years, the Treasury estimates. It would generate taxes for several reasons: for one taxpayers would lose the tax break of IRAs and could elect to pay a tax penalty to convert existing retirement accounts. But analysts say the plans would mean lower government revenues in future years as individuals draw down their accounts or pass them on to heirs free of taxes.

The proposal also would affect the 401(k) plan — the heart of retirement savings for many private company employees. The plans would be renamed Employee Retirement Savings Accounts, with no change in rules that currently allow workers to contribute up to $12,000 in pretax income annually. But other rules governing the 401(k) would be eased to encourage more small businesses to participate. And the ERSAs would consolidate separate but similar programs including 457 and 403(b) plans for government and non-profit employees.

For many individuals, the availability of the new options would mean tough choices over whether to roll over existing accounts and pay taxes up front in exchange for the potential future tax benefits. For many the trade-off would be worth it, although some investors got burned several years ago when they paid to convert their Individual Retirement Accounts to Roth IRAs, only to see the value plummet in the stock market meltdown.

Still other investors might consider shifting money away from 401(k)s into the new accounts, betting that the future benefit on accrued earnings will be worth far more than the present tax benefit.

Similarly owners of small and even large businesses would face new considerations in deciding whether to take advantage of the rules to offer a new company retirement plan or perhaps to terminate an existing plan and allow employees to fend for themselves.

“I’m confident that simpler rules will encourage employers to create new plans for their employees because creating a qualified plan will be much easier,” Assistant Treasury Secretary Pamela Olson said in a statement describing the proposal.

Others are not as confident.

“We think that despite their good intentions this plan probably is going to be counterproductive in advancing retirement security for workers,” said Ed Ferrigno, vice president of the Profit Sharing/401(k) Council of America, which represents employers. “We think it will reduce the number of small employers offering plans.”

The reason, he said, is that the RSAs and LSAs would offer small-business people far more options to save for their own future, eliminating some of the incentive to offer 401(k)-type plans. Many small-business owners currently offer 401(k) plans to their employees at least partly because government regulations require them to do so in order to participate themselves.

Ferrigno said it might not matter if fewer people had access to company retirement plans as long as they saved in the new plans. “But we don’t think as many people would save” in the new plans, which would lack the incentive of company matching.

The plan has been welcomed on Wall Street, where hard-hit brokerage firms are looking for any way to lure Americans back into the stock market after three years of heavy losses. “Higher contribution limits and the elimination of eligibility based on income for Roth IRAs will mean that more Americans can save more money and benefit from withdrawing their gains tax-free,” said Elizabeth Varley, vice president of the Securities Industry Association, a trade group for brokerages.

But the reaction might not be so warm from mutual fund companies like Vanguard, Fidelity and T. Rowe Price that have spent millions of dollars marketing their investment management services to big companies offering 401(k) plans, said Joshua Dietch, associate director of Cerulli Associates, a consulting firm.

“The cream could get skimmed right off the top by the brokerage firms,” he said. And the new rules raise the question of whether brokerages would be restricted in the type of advice they offer to investors, who enjoy legal protection against aggressive sales pitches in their 401(k) plans.

But he said he would have “loved” to have access to a Lifetime Savings Account several years ago when he was forced to pay a penalty to cash in some Individual Retirement Accounts to buy a house.

One thing is certain: No matter how much the administration stresses that its objective is to “simplify” the retirement system, any such overhaul would create plenty of work for financial planners, lawyers, accounts and trust officers sifting through the new options for their clients.

“These simplified plans they are talking about will likely end up being nowhere near as simple as they are talking about,” said Steve Leimberg, who publishes several online newsletters on tax and retirement planning. “Nothing to do with the tax code is ever simple.”