May 15, 1998
Using IRA Tax Break to Fund IRS Reform
Leaves Revenue Hole When Baby Boomers Retire
by Iris J. Lav
The version of the Internal Revenue Service reform bill (H.R. 2676) the Senate passed on May 7, 1998 will cost about $18 billion over the next 10 years. A number of small tax increases are included in the bill to offset its cost. Remarkably, one of the revenue raising offsets which finances $8 billion of the bill's $18 billion cost is not a tax increase but a tax cut. It is an extension of the Roth IRA tax break enacted last year to a specific group of higher-income taxpayers who are not now eligible for it.
This IRA change would raise $8 billion in the first three years it is proposed to be in effect from 2005 through 2007. But the revenue gain is only temporary. In the subsequent 10-year period from 2008 to 2017, the IRA modification would lose $13 billion in revenue. As a result, the total package of revenue offsets in the Senate IRS reform bill that raises $18 billion over the 1998-2007 period would not continue to raise revenue but instead would lose approximately $4 billion over the subsequent 10 years from 2008 through 2017.
The Internal Revenue Service reforms that are financed by the revenue offsets do not, however, decline in cost over time. To the contrary, the cost of the reforms in the Senate bill more than doubles from the beginning to the end of the first 10 years the legislation would be in effect, from $1.3 billion in 1999 to nearly $2.9 billion in 2007. A number of the reforms are rising in cost substantially in the last few years before 2007 and cost increases can be expected to continue in subsequent years. Although the cost of the Senate reforms will be $18 billion from 1998 through 2007, the cost is likely to rise to the range of $40 billion to $46 billion in the following 10 years from 2008 through 2017.
Cost of Senate IRS Reform Bill
1998 to 2007
2008 to 2017
Cost of Reforms $18.3 billion $40 billion to $46 billion Revenue Offsets $18.0 billion -$4 billion Net Cost -$0.3 billion $44 billion to $50 billion Source: The 1998-2007 estimates are from Joint Committee on Taxation, JCX-32-98. Estimates for 2008-2017 are the author's, based in part on a letter from JCT to the Senate Finance Committee Minority staff director, May 5, 1998.
The result of the Senate bill would be an unfunded cost totaling $44 billion to $50 billion from 2008 through 2017. This is the sum of the $40 billion to $46 billion cost of the reforms in those years and the additional $4 billion revenue loss from the offsets. The timing of these revenue losses is of particular concern because both the Congressional Budget Office and the General Accounting Office project that federal budget deficits will once again appear around or shortly after 2015, as the vanguard of the baby boom pushes toward 70 years of age.
The sole beneficiaries of the IRA expansion would be older taxpayers with incomes exceeding $100,000 and their heirs the highest-income five percent to seven percent of the senior citizen population. At a time when the nation faces long-term deficits in the Social Security and Medicare systems on which millions of elderly and disabled Americans rely for support of basic needs, providing a new tax break that enables the most affluent elderly to become yet more affluent is not the budget priority on which most Americans would knowingly choose to spend $13 billion.
How the IRA Provision Works
The IRA provision in the Senate legislation would allow some elderly taxpayers (age 70½ and above) with annual incomes in excess of $100,000 to convert their existing, conventional Individual Retirement Accounts into so-called Roth IRAs. Under current law, only taxpayers with incomes below $100,000 may make such conversions. The new type of Roth IRAs enacted as part of the Taxpayer Relief Act of 1997 differ from conventional IRAs in ways that would make conversions attractive to these relatively well-off taxpayers.
Under conventional IRAs, qualified taxpayers may deduct from their taxable income each year up to $2,000 in contributions to their accounts.(1) Once the contributions are made, earnings on the deposits accumulate free of tax. Income taxes on the principal and interest are deferred until the funds are withdrawn. Taxpayers who reach age 70½ are required to begin taking distributions from their conventional IRAs, with the amount of the required annual distribution determined by IRS life-expectancy tables. The distribution is counted as part of the taxpayers' income and is taxable in the year in which it is taken.
In contrast, contributions made to Roth IRAs are not deductible from taxable income. But all earnings on Roth IRA deposits are forever free of tax. Thus, all qualified withdrawals from Roth IRAs are free of tax. (The principal already has been taxed and the earnings are not taxable.) Moreover, there is no requirement to take any distributions from Roth IRAs. If a taxpayer over age 70½ chooses to leave funds on deposit in a Roth IRA, ultimately the beneficiary of his or her estate will receive the funds without having to pay any income tax on the inheritance.(2)
Moreover, an heir may be able to keep the bulk of the funds from an inherited Roth IRA on deposit, with earnings continuing to compound free of tax. Heirs appear to be required to take distributions from the inherited accounts only gradually, spread over the course of their own life expectancies.
Under the provisions of the 1997 law establishing the Roth IRAs, individuals or couples with incomes below $100,000 who hold conventional IRAs may elect to convert those accounts to Roth IRAs. Taxes must be paid on the amounts "rolled over" from the conventional IRA to a Roth IRA at the time of the conversion. Once the rollover is made, all subsequent earnings on the account are tax free.
The proposal in the IRS reform bill would allow some taxpayers who have reached age 70½ to roll over the conventional IRAs they hold to Roth IRAs, even though their incomes exceed the eligibility ceiling of $100,000. Technically, the rules would be modified as follows. Under current law, taxpayers who have reached age
70½ are required to take distributions from their conventional IRAs, and those distributions are counted as part of the taxpayer's income. Under the proposed change, the minimum required distribution from a conventional IRA would be excluded from income for the purpose of determining whether a taxpayer age 70 ½ or older is qualified to convert a conventional IRA to a Roth IRA. This would allow some taxpayers with incomes that exceed $100,000 when their IRA distributions are included to become eligible to make the IRA conversion.
For example, an individual with income from Social Security, taxable pension, and ordinary investments of $90,000 might be required beginning at age 70½ also to take an annual minimum distribution of $30,000 from his or her conventional IRA holdings. This would raise the individual's adjusted gross income to $120,000. Because the individual's income exceeds $100,000, he or she cannot convert a conventional IRA to a Roth IRA.
Under the change proposed in the Senate version of the IRS reform legislation, only the $90,000 portion of the individual's income would count for purposes of the income ceiling. The individual in the example could convert the amount remaining in his or her conventional IRA to a Roth IRA. Tax on the amount in the account would be due at the time of the rollover. But no additional taxes would be due in the future regardless of how much income was earned on the invested funds.
Depending on the rate of return earned on the investment subsequent to the conversion and the length of time the funds are held, the prepayment of the taxes could result in a substantially lower total amount of taxes paid on funds in the accounts. Moreover, the rollover of the funds to a Roth IRA would relieve the taxpayer of the obligation to take distributions of funds from the IRA. The couple could choose to leave the funds on deposit, and the funds ultimately would become a tax-free bequest to their heirs.
Who Would Benefit From the Proposed IRA Expansion?
The sole beneficiaries of this proposal would be older taxpayers with incomes exceeding $100,000 and their heirs. All taxpayers with incomes under $100,000 already are eligible under current law to convert their conventional IRA holdings to a Roth IRA.
There are very few older taxpayers who are prevented from making conversions because of the income ceiling. Census data show that in 1996 only 3.3 percent of all households headed by a person age 65 or older had income of $100,000 or more. Even considering households with incomes of $75,000 or more because non-wage income of the type generally received by retirees tends to be somewhat under-reported only 6.5 percent of the households of the elderly have incomes this high.(3) So at least 93 percent and probably about 95 percent of all individuals and families in the age group covered by the proposed expansion already have the right under current law to convert their conventional IRAs to a Roth IRA.
As a result, the new tax break in the IRS reform bill will exclusively benefit the highest-income five percent to seven percent of the senior citizen population. These generally are retirees whose non-IRA income is close to $100,000, reflecting earnings on large holdings of investments on top of pension or Social Security income. If faced with the question of how to spend the $13 billion in federal funds this provision will cost in the 10 years after the initial surge of conversions is completed, most Americans would not put the most affluent segment of the elderly population at the head of the line.
The other group that stands to benefit substantially from this proposal is many of the heirs of these best-off five percent to seven percent of senior citizens. As noted, elderly holders of Roth IRAs who do not need to withdraw funds for living expenses need not take distributions from their accounts. When the holders of the accounts die, their heirs can receive the balances free of income taxes and may in addition be able to continue to enjoy the continued buildup of tax-free earnings in the accounts for many years into the future. The creation of a new stream of tax-free income for the heirs of the highest-income senior citizens in the country is a strange budget priority at a time when solutions are being sought to ensure the solvency of the Social Security system upon which millions of elderly and disabled Americans rely for support of their basic needs.
Borrowing from Future Revenues
The IRA proposal was inserted into the Senate IRS reform bill as an amendment on the day before final passage because additional funds were needed to cover the cost of the Senate bill over the first 10 years. While the House version of the IRS reform would cost an estimated $6.2 billion in the 1998-2007 period, the Senate bill's $18.3 billion cost over the 10 years is nearly three times as high. The Senate needed additional savings to offset the higher cost of its version of the bill.
Figure 2 will be posted shortly
The Senate bill delays this change in IRA policy until tax year 2005. If this is good policy, why is its effective date delayed so long? If the policy raises rather than loses revenue, why shouldn't it start immediately? The answer, of course, is that the proposal is a large tax cut that raises revenue only in the first few years it is in effect, when significant numbers of taxpayers are assumed to roll over deposits from conventional IRAs into Roth IRAs and pay taxes that otherwise would be due in subsequent years. If the change were made effective earlier in the 10-year period, it would lose rather than raise money over the 10-year time frame, and the IRS reform bill would not be fully funded during that period.
Why does the provision gain substantial amounts of revenue for a few years and then cause revenue losses in subsequent years? The offer to convert is an attractive one because it affords some relatively high-income, older taxpayers a way either to lower the total taxes they will pay on their accumulated IRA deposits or to pass funds remaining in their IRAs to their heirs free of tax. There is a large revenue gain in the first few years after enactment, because it is assumed that substantial numbers taxpayers over age 70½ who newly have the opportunity to take advantage of these tax breaks will do so. When taxes are paid on total amount of the deposits that are converted from conventional IRAs to Roth IRAs, the federal government receives more taxes than it would take in under current law.
Once the rush of conversions is over, however, the federal government will be receiving less revenue than under current law. The annual taxes on the minimum required distributions from the conventional IRAs will no longer be paid on accounts that have been converted. In addition, unlike under current law, income taxes will not be paid when IRA balances pass to heirs. Furthermore, there will be fewer large tax payments from additional conversions in years subsequent to 2007, since once the initial rush of conversions is completed only taxpayers first turning age 70½ will be newly eligible for this tax break. Most taxpayers over that age for whom the conversion is advantageous likely will have made the change in the first three years.
The Joint Committee on Taxation's revenue estimate for the IRS reform bill extends only through 2007, so it shows only the $8 billion gain the IRA provision would produce in the three years after the provision first becomes effective in 2005. Another Joint Committee on Taxation estimate, however, shows a 10-year estimate for the same provisions assuming they were put in place this year. That estimate shows revenue gains of approximately $3 billion in each of the first three years, but revenue losses beginning in the fourth year that rise to an annual revenue loss of $1.7 billion by the ninth year.(4) (See Figure 2.) The IRA provision in the IRS reform bill undoubtedly will follow a similar revenue-loss path in years subsequent to 2007.
Revenue Offsets Will Not Support Continuing Cost of Reforms
A number of the IRS reform provisions included in the Senate bill grow significantly in cost over time. These include items such as the innocent spouse relief, with costs growing from $350 million in 1999 to $1.1 billion in 2007; the elimination of penalties during installment agreements, which grows in cost from $272 million in 1999 to $410 million in 2007; and the suspension of interest and penalties when the IRS fails to contact a taxpayer within 12 months after a timely-filed return, for which costs rise from $358 million in 2000 to $628 million in 2007. The cost of all the reforms together more than doubles from the beginning to the end of the first 10 years the bill would be effective, from $1.3 billion in 1999 to nearly $2.9 billion in 2007. Over the first 10 years, the reforms would cost a total of $18.3 billion.
The costs of many of the reforms are rising rapidly in the years at the end of the 10-year estimation period. Over the last four years from 2004 through 2007, according to the Joint Committee on Taxation estimate, the cost of the reforms is increasing by $208 million each year, at an average annual rate of 8.6 percent. If it is assumed that the costs continue to grow by the same dollar amount each year over the next 10 years (rather than at the same percentage rate), a conservative assumption that does not account for cost inflation, the package of reforms would cost $40 billion from 2008 through 2017. Alternatively, if it is assumed that the cost of the reforms continues to grow at the same rate as it is growing at the end of the first 10-year period, the reform package would cost $46 billion from 2008 to 2017.
Whether the cost in the second 10 years after enactment is $40 billion or $46 billion, a revenue package that loses $4 billion certainly cannot offset that cost.
Revenue Losses Will Exacerbate Deficits When Baby Boomers Retire
At a time when the federal budget surplus seems to grow with every new estimate, a $45 billion to $50 billion revenue loss over 10 years may not seem so significant. The fact that there are projected to be budget surpluses in coming years, however, does not change the fact that a long-term, demographically-driven budget deficit is expected to develop in the second decade of the 21st century and to deepen substantially in subsequent decades.
The baby-boom generation will begin retiring in large numbers after 2010, and CBO director June O'Neill has testified that CBO expects deficits in the unified budget to return after 2015. The revenue losses that will result from the Senate version of the IRS legislation would occur at the same time the baby-boom generation begins to retire and federal budget deficits are projected to reappear. It would be far more responsible to eschew gimmicks and fund the IRS reforms with revenue offsets that can grow along with the costs of the reforms.
1. Taxpayers who are not covered by an employer-sponsored retirement plan and taxpayer who have incomes below specified levels are eligible to make deductible contributions to conventional IRAs.
2. While no income taxes would be due, estate or gift taxes may apply to the bequest if it is of sufficient size. The first $625,000 of an estate is exempt from tax, with the exemption scheduled to rise to $1 million by 2006.
3. Bureau of the Census, Money Income in the United States: 1996, Table 2.
4. Letter to Senate Finance Committee Minority staff director Mark Patterson, May 5, 1998. The estimate specifies the provision would be effective for tax years beginning after December 31, 1997. No revenue change is shown for fiscal year 1998, however, presumably because the provisions would be enacted too late to have an impact.