Updated: May 3, 2013 12:14PM
Originally published: February 26, 2003
The rules of the money game are changing, and those who respond quickly to the new incentives for saving instead of borrowing will benefit the most.
For decades, Americans have been rewarded for spending and penalized for saving. The spending habit was encouraged years ago when interest paid on consumer debt was tax-deductible. In more recent years, creative financing and widespread availability of credit led Americans to finance their lifestyles on credit cards and home equity loans. The result is that the ratio of debt to personal income today exceeds 100 percent.
Now the wheel of fortune has turned. Future bonuses will come to those who save--in the form of tax-free gains. And the penalties will be felt by those who are in debt, and whose payments will rise along with interest rates. The clearest example of the changing times is the incentives offered in President Bush’s proposal to create vastly simplified savings plans.
They’ll take away all your excuses for spending instead of saving.
These two new accounts--the Lifetime Savings Account (LSA) and Retirement Savings Account (RSA)--will replace all the regulated and restrictive plans that currently discourage personal savings. And all those complicated retirement plans at work, such as 40l(k), 403(b), 457 plans, would be covered by one new workplace plan: the Employer Retirement Savings Account (ERSA).
Of course, these proposals have to pass Congress. And even though both the House of Representatives and the Senate are controlled by the president’s Republican Party, there’s bound to be some debate and trade-offs. There’s concern that these tax-free withdrawals could add to huge projected budget deficits. On the other hand, there could be an immediate multi-billion dollar windfall if individuals convert older plans to these new tax-free programs.
The new trend is in motion, and there has been no organized political opposition to these new savings plans. So it’s worth re-thinking your personal financial strategies to take advantage of these opportunities if and when they become available.
LSA: Something for everyone
The most obvious beneficiaries are people who already have some savings outside existing retirement plans. You could simply switch $7,500 from your current CDs or mutual funds to each of these new accounts, and all future gains would come out tax-free.
But even people who could set aside only a small amount of savings each month into an LSA would benefit. Why should only the wealthy have access to tax-free municipal bonds and other sophisticated investments that provide tax-sheltered income? Now even a passbook savings account at a bank could be designated as part of an LSA. And with tax-free gains, and no restrictions on withdrawal for any reason, more people would be enticed to save money instead of spending it.
What should you do? If LSAs become a reality, you’ll want to set aside all the money you can in one of these accounts.
You could have different types of investments in an LSA. Perhaps a non-risky money market account would be the best place for your savings if you’re putting away money for emergencies or accumulating a down payment for a home. But you could also invest in a mutual fund for the long run, taking out the gains tax-free.
And now you have a reason for distributing money to your children or grandchildren. The money can be put into an LSA (with a trustee for minor children), where it will grow tax-free. Of course, the money belongs to them with no restrictions on withdrawals after they reach age 18.
If you already have one of the older, more complicated and restrictive plans such as a Coverdell Education IRA or Archer Medical Savings Account (MSA) or a Qualified State Tuition Plan, it could be converted to an LSA, but that must be done by the end of 2003.
RSA: Better retirement option
The personal retirement savings account (RSA) will work like a giant Roth IRA, allowing you to put away $7,500 after-tax dollars every year to grow tax-free.
It’s designed to eliminate the confusing mess of IRAs, Roth IRAs, SIMPLE plans and many others. There will be no income restrictions to an RSA, but the contributor must have earned income. And all withdrawals will be tax-free. There will be no required minimum distributions from RSAs, eliminating a huge hassle for calculations in most current IRA plans.
You’ll still be able to keep your traditional IRA or IRA rollover account, but you won’t be able to add any more money to it. And you’ll still be able to roll over your 401(k) or other company plan to an old-fashioned IRA rollover. For those older accounts, you’ll pay ordinary income taxes when you do withdraw money from them.
But you will be allowed to convert those older plans to the new RSA plan. No one would be required to convert, but if you do convert, you would have to pay taxes on the value of your account, since it was all pre-tax contributions in the first place.
If you do convert before Jan. 1, 2004, you can actually spread the conversion tax over four years. There is no limit to how much you can convert if you can afford to pay the tax. And there is no income limit on eligibility to convert to a new RSA.
What should you do? If the proposal passes, this might be an excellent time to do that conversion of your old IRA to a new tax-free RSA. Your portfolio value has probably dropped substantially, meaning you’ll have to pay less in taxes on the existing account. Then all future growth when the market eventually rebounds will come out tax-free!
ERSA: Good and bad news
The Employer Retirement Savings Account has both good news and bad news for individuals. The good news is that the ERSA eliminates so many confusing corporate and government retirement plans, and all the restrictions on those plans, so more employers will set them up. The bad news is that matching contributions, typical under 401(k) plans, will be eliminated.
If the proposal passes, all 401(k) plans will automatically become ERSAs. The ERSA plan still gives the employee a tax deduction for a contribution. The limit will be $12,000 per year, increasing to $15,000 in 2006. Additionally, once the employee reaches age 50, a catchup contribution of $2,000 can be made, increasing to $5,000 in 2006.
What should you do? Keep contributing to your current 401(k) plan, at least enough to get the employer match. And if the law changes--and matching contributions disappear--you might press your employer for a bonus so you can contribute to the personal RSA. That would still be a deduction to the employer, though it would be taxable income to you.
One more thing: If your company doesn’t have any retirement plan, remind the boss that it will be much easier and less costly to set up the new ERSA plan.
The Savage Truth
Didn’t you always wonder how the “smart money” figured out how to get ahead by being there first?
They aren’t playing yesterday’s game, but instead they’re looking ahead to where the incentives and rewards will lie in the future.
Well, the use of debt is yesterday’s game. Tomorrow’s incentives revolve around saving and investing. The plan now going to Congress creates huge rewards for those who start thinking, planning and moving in this new direction. And that’s The Savage Truth.
Terry Savage is a registered investment adviser and is on the board of directors of McDonald’s Corp. She appears weekly on WMAQ-Channel 5’s 4:30 p.m. newscast.