March 28, 2000

IRA Expansion Nestled in Managed Care Legislation
Would Provide Costly Tax Break for Wealthy Individuals

by Iris J. Lav

The Senate version of managed care legislation now in conference includes a costly IRA expansion that has nothing to do with health care and that solely benefits individuals who are among the highest-income six percent of taxpayers and their heirs. This unrelated tax break for high income taxpayers is responsible for nearly half of the cost of the Patients' Bill of Rights in the 2005-2009 period, the second five years it would be in effect.(1)

The provision would allow taxpayers with incomes up to $1 million to roll over deposits currently held in conventional, deductible IRAs into Roth IRAs. That would result in large new tax breaks for many very affluent individuals.

The 1997 tax legislation establishing Roth IRAs recognized how lucrative the opportunity to convert conventional IRAs to Roth IRAs would be for high-income taxpayers. As a result, the legislation permitted conversion only by taxpayers with incomes below $100,000. Raising the current $100,000 ceiling to $1 million would benefit solely those individuals with incomes between $100,000 and $1 million, all of whom are among the highest-income six percent of taxpayers, providing substantial tax advantages to these individuals and their heirs.

Conventional IRAs, Roth IRAs, and Conversion of
Conventional IRAs to Roth IRAs

Under conventional IRAs, taxpayers receive a tax deduction when they deposit funds in an IRA account. Earnings on conventional IRA accounts are not subject to tax until funds are withdrawn from these accounts during an account-holder's retirement years. When distributions are made from these accounts, the total amount withdrawn — the principal and accumulated interest — is subject to tax. It should be noted that taxpayers are required to begin taking distributions from conventional IRAs no later than at age 70½.

By contrast, under Roth IRAs, no deduction is provided when funds are deposited, but all interest earnings are forever free of tax; no taxes are imposed when funds are withdrawn from these accounts during retirement. Also of note, taxpayers are not required to withdraw any funds from these accounts during retirement; they can bequeath these accounts in full to their heirs.

The 1997 tax legislation that established Roth IRAs allows taxpayers with incomes of less than $100,000 to convert (or "roll over") conventional IRAs to Roth IRAs. Income tax is paid on the funds in a conventional IRA when the funds are converted to a Roth IRA, instead of the tax being paid over a period of years as the taxpayer withdraws funds from a conventional IRA after retiring. Once funds in a conventional IRA are converted to a Roth IRA, all future earnings are tax-free.

This tax break in the Senate managed care bill is expected to result in a flood of well-to-do people seeking to capture these lucrative new tax benefits. As a result, the Joint Committee on Taxation estimates the tax break will raise $6.6 billion in the four years from 2000 through 2003, as affluent individuals convert their conventional IRAs to Roth IRAs and pay taxes in those years they otherwise would have paid in later years when they withdrew funds from these accounts after retirement. Beginning in 2004, however, the provision would lose sizable amounts of revenue.

Figure 1

There are a number of reasons that converting conventional IRAs to Roth IRAs is likely to be more advantageous and lucrative — and more costly to the government — for taxpayers with incomes over $100,000 than for those with incomes below that level, who already may make such conversions under current law. Higher-income taxpayers may have accumulated more funds in conventional IRAs than taxpayers with incomes below $100,000.(2) Once these larger balances are converted to Roth IRAs, the earnings on these large deposits will never be taxed. In addition, higher-income taxpayers are less likely to need the funds they have accumulated in their IRA accounts for income support in their retirement years, and may be more likely to want to switch to Roth IRAs for purposes of enhancing the estates they will leave to their heirs. This could further reduce both income tax and estate tax collections.

Figure 2

As noted, the sole beneficiaries of this proposal would be the approximately six percent of taxpayers with adjusted gross incomes exceeding $100,000 and their heirs.(3) All taxpayers with incomes under $100,000 already may convert conventional IRA holdings to Roth IRAs.

This expanded tax break, which also was part of the original Senate version of the tax bill that President Clinton vetoed last year, has nothing to do with the purpose of the Patients' Bill of Rights.(4) It neither improves the quality of health care nor expands access to health services. The House bill contains no comparable provision. The Senate's IRA expansion should be dropped in the conference committee.

End Notes:

1. The Joint Committee on Taxation's revenue estimate was done in 1999 and covers the 2000-2009 period.

2. Since the Tax Reform Act of 1986, taxpayers who are covered by an employer-sponsored retirement plan have been allowed to make deductible contributions to IRAs only if their incomes are below specified levels. The current income limits are $62,000 for joint filers, rising to $100,000 for joint filers in 2007. Many taxpayers with current incomes above $100,000 may nevertheless have funds on deposit in conventional IRAs stemming either from years in which their incomes were lower or from the period before 1986 when there were no income limits. In addition, higher-income taxpayers who are not covered by an employer-sponsored retirement plan may have significant amounts of accumulated contributions in conventional IRAs.

3. Those with adjusted gross income exceeding $1 million a year would not qualify, but they account for only one-tenth of one percent of taypayers.

4. The Senate version of H.R. 2488 would have increased the income limit for rollovers to $1 million. The conference version that was vetoed would have increased the limit to $200,000.