Uncle Sam Is Coming After Your Savings

1/24/2015

FIRST HE CAME FOR YOUR 529'S...

By Megan McArdle

Earlier in the week, I discussed the Obama administration's proposal to tax earnings on so-called 529 college savings plans, part of a package of tax hikes that will pay for new programs such as his proposal to make the first two years of community college free. This has been touted as a plan to hike taxes on the rich to help the middle class, but in fact it's more of a plan to redistribute money from the upper middle class to the lower middle class.

As I noted then, this proposal is not going anywhere, not just because Republican congressmen will block it, but because it would be very unpopular with affluent blue-state voters who currently vote for Democrats. About the only people I saw defending this particular idea were blue-state singles who haven't yet confronted the monstrous expense of shepherding their progeny into the new mandarin class to which they belong.

Everyone else seems to be somewhere between confused and aghast. One comment in particular struck me, as I saw it several times on social media and in writings: "How would you feel if they did this to Roth IRAs?"

Why did I find that particular question a compelling topic for a column? Because it's a question we may have to ask ourselves. As I observed when I first wrote about the plan, the very fact that we are discussing taxation of educational savings -- redistributing educational subsidies downward -- indicates that the administration has started scraping the bottom of the barrel when seeking out money to fund new programs. Why target a tax benefit that goes to a lot of your supporters (and donors), that tickles one of the sweetest spots in American politics (subsidizing higher education), and that will hit a lot of people who make less than the $250,000 a year that has become the administration's de facto definition of "rich"? 

Presumably, because you're running out of other places to get the money. The top tax rate on people who make more than $413,000 ($464,000 for married couples) is already almost 40 percent. That's on top of Medicare taxes (2.9 percent, not capped), Social Security taxes, state and local taxes (in a deep blue area like New York City, these can amount to 10 percent, though you get some of that back by deducting state taxes from your federal tax) -- a marginal tax rate of around 45 to 50 percent in blue states, and possibly even more if you run a business.

Capital gains are taxed at a lower rate, of course. But if you combine the Obamacare capital income surcharge for higher earners, and the administration's new proposal to raise the base rate to 28 percent, you're looking at a capital gains tax of almost 32 percent for people who make more than $200,000 a year ($250,000 for married couples). We are simply running out of room to pay for generous new programs with higher taxes on the small handful of people who make many hundreds of thousands of dollars a year. I'm not saying that it's impossible, politically or otherwise, to further raise their tax rates. I'm just saying that there's not all that much money there left to get. 

Yes, I know that tax rates used to be much higher in the middle of the 20th century. However, eye-popping, high-double-digit rates fell on a much smaller share of the population, and therefore didn't raise all that much money; they were mostly symbolic, especially since they were combined with a much more generous array of deductions. Also, there's a reason that countries largely stopped trying to enact such heavy tax rates; in an era when global capital, and people, move pretty freely, they turned out to be mostly counterproductive. This is also why we don't try to tax the bejesus out of capital income, much as many would like to; old capital flees, and new capital doesn't get formed, as savers decide it's not worth it.

What that tells us is that politicians will need to reach further down the income ladder in order to fund new spending -- indeed, to fund the spending we've already done, in the form of entitlement promises. Where will they go for that money?

Once you've hit your fiscal capacity to tax the rich,  a few big sources of tax revenue are left:

1) A value-added tax. Very efficient and generates a lot of money because evasion is very difficult; it is almost self-enforcing. It minimizes economic distortion, and what distortions it does introduce encourage savings over consumption. It is also highly regressive. So it's hard to see where the political support will come from: Progressives hate the regressivity, conservatives, the imposition of a large new tax that will squeeze a lot of money out of people.

2) Raising income taxes on the middle class. Also raises a lot of money -- the middle class mostly have salary income, and they don't have the ability of the wealthy to shift their income between, say, capital gains and ordinary income. This will raise a lot of money (note that the Bush tax cuts on the middle class, which were made permanent in 2010, cost about three times as much as those on the wealthy.) It will also rile many millions of people, who will make angry phone calls to their representatives.

3) Tax the savings of the middle class. This could take many forms: lowering the dollar value of an estate that is exempted from tax, eliminate the basis-step up that such estates currently enjoy, or start to pare back on tax-advantaged savings like Roth IRAs and 529 educational savings accounts.  (Traditional IRAs and 401(k)s already have their withdrawals taxed as ordinary income, which will make it harder for the government to claw back the tax benefit they've already extended without outright seizing the accounts.) This will also cause a mass freakout, but of a smaller number of people, since a surprising number of affluent people save very little of their income. 

The third option is the worst, from an economic point of view -- the last thing we want to do is discourage saving, given how little of it Americans do. On the other hand, it may be the most politically palatable.

Does that mean you should forget the Roth IRA?

I've thought a lotabout this question , and the tentative conclusion I have come to is that you have to save the money somewhere, so you might as well put it in a tax-advantaged account. Yes, I understand the temptation to implement Plan Grasshopper in the face of future tax hikes, but before you pull the trigger, I suggest you try to draw up a household budget living only on what you're likely to qualify for in the way of Social Security benefits. I'd rather live comfortably with a higher tax rate than scrape along on what the government will give me.

And there are real benefits to a Roth IRA. For one thing, because you put in post-tax dollars, you have to save more and consume less now, which is good fiscal discipline. For another, there's a good chance that any future attempt to tap this money will -- because of the political optics -- come in the form of taxing only future contributions, rather than contributions that have already been made. This seems worth the risk to me, though I certainly see the arguments against.

What it does argue for is diversifying where you put your money: some in traditional IRAs and 401(k)s, some in Roth, and hopefully, some in regular taxable accounts, because you've already maxed out your tax-advantaged contributions. That way a change in a single program doesn't radically alter your retirement and college plans.

What it also argues for is saving even more than you  are. The government is going to come for its money one way or another, and the best way to deal with that is to have more than you need. 

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