Individual Retirement Accounts (IRAs): Issues and Proposed Expansion

Publication Date: March 2003

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Banking and finance

Type:

Abstract:

The Taxpayer Relief Act of 1997 increased benefits available under individual retirement accounts and provided for a particular type of account called a Roth IRA. President Clinton had subsequently proposed a provision that was particularly directed at lower income individuals (Retirement Savings Accounts). The 2001 tax cut liberalized contribution limits (but not income limits) for IRAs and added a temporary savings credit directed at lower income individuals. In 2003, President Bush proposed to combine all IRAs into Roth types and to remove income limits. (Special accounts dedicated to education are not considered in this paper).

Deductible contributions to IRAs can currently be made by individuals not covered by a pension plan and, under the 1997 revisions, to individuals with a plan up to an income limit. (Accounts with tax deferrals are available to everyone). The treatment is similar to that of a pension plan - contributions are deducted and withdrawals are taxed. This approach is also called a deductible or "front-loaded" account. The 1997 legislation also allowed a new type of IRA (the Roth IRA), where contributions are not deductible, but no tax is imposed on withdrawal (similar to the treatment of a tax exempt bond). This approach is also called a non-deductible or "back-loaded" plan. Both IRAs have income limits, with the limits higher for Roth IRAs. Back-loaded accounts are similar to front-loaded approaches in that they effectively exempt income from taxation under certain circumstances but differ in several ways including the structure of penalties for early withdrawals.

The major argument for IRAs is that they will increase private savings. In general, however, neither conventional economic theory nor the empirical evidence on savings effects tends to support an expectation that increased IRA contributions are primarily new savings. Back-loaded accounts are less likely to induce new private savings than are front-loaded ones. Recent evidence of the uncertainty of increasing savings with a higher rate of return is the juxtaposition of high returns in the stock market with a dramatic reduction in the personal savings rate. This fall in the savings rate in the face of high returns provides some evidence that expanded IRAs will not be successful in increasing savings rates.

Because of rollovers, phased in income limits, and the initial small accumulations of contributions in back-loaded plans, the 1997 IRA expansion had a very small revenue cost in the first few years, but will cost much more in the future. The cost of the Administration's proposal will also grow over time. IRA provisions are also viewed as a middle class savings plan. Although plans are phased out for very high income individuals, the participation in 1981-1986 when there were no income limits was largely by the upper part of the income distribution; a limit increase and income increase will be more focused on higher income individuals.

The Clinton Administration's RSA plan had larger per dollar subsidies, that are more limited in size and income eligibility than IRA expansion. RSA benefits would have been more targeted than IRAs to lower and moderate income individuals. This report will be updated as legislative developments warrant.