Congress' tax-free savings accounts expanding, but the rich benefit most

Author: Marilyn Geewax

Published: December 7, 2003

WASHINGTON -- If you save money, the government will reward you with tax breaks.

It's such a popular idea that Congress keeps finding more reasons to offer it. First, lawmakers offered tax benefits for retirement saving. Then came more breaks for people who save money for health costs, dependent care and college.

But an escalation of tax-advantaged savings accounts in the new Medicare bill, plus the Bush administration's plan to create a new variety next year, are raising questions about the accounts' fairness to low-income people and their potential to expand the federal deficit.

Supporters say tax incentives encourage saving, which creates the pools of capital that businesses need to buy equipment and hire workers.

But critics say they represent one more tax break for the wealthy, pointing to signs that many U.S. households can't afford to take advantage of the savings deals.

For example, about two-thirds of households have savings of less than $10,000. And although the country has more than 70 million children younger than 18, fewer than 3 million tax-advantaged "529" savings accounts for tuition have been opened, according to Cerulli Associates, a Boston-based research firm.

Studies also show that most of the benefits of tax-advantaged retirement accounts go to the highest wage earners. The poorest 40 percent of households have only about 5 percent of the assets in these accounts, while the richest 10 percent have more than half, according to a Harvard University study.

Although the tax breaks help relatively few Americans, they reduce revenues that could shrink the federal deficit or finance programs that help average- and lower-income households, the critics argue.

As the accounts proliferate, "we're digging a deeper and deeper hole in the deficit, one shovelful at a time," said William Gale, an economist at the Brookings Institution, a liberal-leaning research group in Washington.

The White House estimated in President Bush's latest budget that tax breaks for retirement would cost the Treasury more than $415 billion between 2004 and 2008.

Gale also disputes the basic assumption that the tax breaks encourage savings. Real savings, he said, come when people decide to temporarily reduce their standard of living to put money away for the future.

Instead, tax-advantaged savings accounts simply encourage affluent people to move cash into tax shelters, he said.

The accounts "reward people for placing assets in certain investments, but do they serve to raise the level of savings? No, largely they don't," he said. "The money just gets shifted."

Despite the proliferation of tax-advantaged accounts, Americans have been saving less. In 1982, when Congress created individual retirement accounts that allowed wage-earners to shelter up to $2,000 annually, the personal savings rate was 10.9 percent. By 2002, the rate was down to 2.3 percent, according to the Commerce Department.

In a review of research on the subject, the Congressional Budget Office concluded that "empirical studies have not been able to resolve the uncertainty about how IRAs affect saving."

Nevertheless, conservatives say the accounts do encourage people to save more.

"When you tax something, you get less of it," said Stephen Moore, president of the Club for Growth, an influential group that lobbies for tax cuts. If Congress reduces taxes on saving, "then you'll get more of it," he said.

Moore said the Bush administration is pushing the nation away from taxing investments, and toward taxing consumption. In the long run, that would help everyone by giving businesses more capital for expansion, he said.

Indeed, the administration has pressed vigorously to expand tax-advantaged savings accounts.

At its urging, Congress last month approved Health Savings Accounts for people younger than 65 whose medical policies have deductibles of at least $1,000, or $2,000 for a family. Unlike other accounts, which exempt either the original investment or its earnings from taxes, money going into the HSAs would be pre-tax dollars. Withdrawals to pay medical bills would be tax-free.

Workers, or their employers, could finance the accounts each year with an amount equal to the deductible, up to $5,150 a year for family plans. That money then could be used to pay for health care expenses, even cosmetic surgery.

Unlike the flexible spending accounts that many employers offer, unused money in the HSAs would not be forfeited at the end of the year but would be reinvested to grow year after year. As a result, HSAs are expected to reduce tax revenues by about $6.4 billion during the coming decade.

In a speech last month, Treasury Secretary John Snow said his staff is also preparing a proposal that would create "lifetime savings accounts" that would let anyone save up to $7,500 annually for any purpose at any time, and pay no taxes on the dividends or stock gains that might result.

The White House also is considering a proposal that would more than double the contribution limit for certain individual retirement accounts, from $3,000 to $7,500, and eliminate the income limits that previously had confined such accounts to middle-income families. Tax-free withdrawals could be made after age 58.

If Congress were to approve both proposals next year, a couple could put up to $30,000 per year into the tax-free accounts -- adding up to an estimated $3 million to $4 million, including interest, over a working lifetime.

"I've been in several meetings with the White House in recent weeks . . . and they are closely contemplating" asking Congress to approve the new accounts, even though lawmakers might be reluctant to do so because of deficit concerns, Moore said.

Daniel Mitchell, an economist for the Heritage Foundation, a conservative research group, said the concerns about the impact of the tax shelters on deficits are overblown. "I don't lose sleep over it," he said.

If Congress wants to reduce the deficit, it should lower spending, he said, adding, "the deficit is the symptom; spending is the disease."

How health savings accounts would work
The accounts will allow some workers to divert part of their pre-tax pay to cover medical costs.

• Who's eligible: Only employees enrolled in company-sponsored health plans with deductibles of at least $1,000 a year.
• How much you can save: Up to $2,250 for individuals, $4,500 for families. Starting in 2005, workers 55 an older would be allowed to add $500.
• How the money can be used: For any medical costs, including chiropractic care, drugs and long-term-care insurance premiums.
• Other features: Unspent money rolls over into the next year. Like 401(k) plans, the accounts can move if employees change jobs.

Savings plans reduce federal tax revenue
Estimated cost from 2004-08 -
401(k) plans $307.7 billion
Individual retirement accounts $108.3 billion
State prepaid tuition plans $2.8 billion
Medical savings accounts $140 million
Source: White House Office of Management and Budget,

Wealthiest benefit most from retirement accounts

Ownership of defined-contribution or IRA assets in households headed by a person age 55 to 59 in 2001
Income percentile Median assets in accounts Share of total assets Under 20
20-39.9
40-59.9
60-79.9
80-89.9
90-100 $0
$0
$7,200
$50,000
$148,000
$215,000 1.1 percent
4.2 percent
8.6 percent
16.7 percent
18.8 percent
50.6 percent

Source: Peter Orszag and Robert Greenstein, Harvard University