Merrill Lynch & Co. Corporate Strategy and Research Corporate and Public Policy Research Comment Assessing the Investment Climate: Focus on Washington

Transcription

1 4 May 1998 Merrill Lynch & Co. Corporate Strategy and Research Corporate and Public Policy Research Comment Assessing the Investment Climate: Focus on Washington The New IRA Rules Should Boost Savings Highlights: Despite a record-breaking economic expansion, the savings rate in the U.S. remains low by historical standards and compared to other major industrialized nations. A shortfall in retirement savings remains a critical public policy issue. Last year's Taxpayer Relief Act of 1997 (TRA '97) included incentives to increase retirement savings. Eligibility for traditional IRAs was expanded, withdrawal provisions were liberalized, and, new, "backloaded" Roth IRAs were created. Do tax incentives boost savings? The academic debate over that question has raged for more than a decade. In our view, tax incentives like IRAs will contribute to a substantial net increase in savings, especially if the applicable tax rules remain consistent. The tax laws governing IRAs were erratic in the 1980s. The IRA provisions in TRA '97 will make many more taxpayers eligible for tax advantaged retirement savings. Depending on their circumstances, some eligible taxpayers will find the Roth IRA more appealing; others will benefit more from the traditional, deductible IRA. Features of the Roth IRA may motivate some savers to keep their savings invested longer. Historically, the participation rate among eligible taxpayers in IRAs and other tax-preferred retirement savings plans, like 401(k) plans, has been too low. Going forward, policymakers must focus on encouraging greater use of available savings vehicles. Some pending proposals are encouraging. As the U.S. enters the seventh year of a record-breaking economic expansion, savings rates continue to disappoint. Indeed, the U.S. personal savings rate was lower in 1997 than it was in 1990, the year before the recovery that kicked off this stretch

2 of growth began. In addition, as Table 1 shows, the U.S. continues to lag its G-7 partners when it comes to saving. The need to boost savings for retirement is a critical issue on the public policy agenda.fewer than half of U.S. workers participate in a pension plan, and individuals aren't saving enough on their own. Studies like the Merrill Lynch Baby Boom Retirement Index indicate that, while there are some signs of an increase in retirement savings, baby boomers need to roughly triple their savings rates to maintain their living standards in retirement. The Taxpayer Relief Act of 1997 (TRA '97) contained a number of measures to stimulate retirement savings, including provisions related to IRAs. TRA '97 expanded the scope of traditional IRAs and created a new "backloaded" IRA, the Roth IRA.Specifically, the law increases the income thresholds that determine deductibility of contributions for workers with employer-sponsored pension coverage. Workers who do not participate in an employer-sponsored plan can continue to make the maximum deductible contribution; workers who are not eligible for any deductible contribution can still make non-deductible contributions to an IRA. The limits on spousal contribution deductibility were also significantly expanded. As a result of TRA '97, individuals will be permitted in some cases to make penaltyfree early withdrawals to finance a first-time home purchase or to pay for higher education expenses. (TRA '97 also established "Education IRAs.") The new Roth IRA allows eligible taxpayers to make nondeductible contributions;future qualified withdrawals of contributions and earnings may be tax-free, if certain criteria are satisfied. TRA '97 gives certain taxpayers who have assets in an existing IRA the option of converting those assets into a Roth IRA. To qualify, the taxpayer must have modified adjusted gross income (MAGI) under $100,000, regardless of whether the taxpayer files a joint or single return. Taxpayers who are married and file separately are not eligible for conversion. Taxpayers who convert must pay income tax on prior tax-deferred contributions and earnings. Taxpayers who convert in 1998 may spread the income pro rata from the conversion over four years and, consequently, spread payment of the income tax owed over a four-year period. Table 2 summarizes IRA provisions resulting from TRA '97. Will New And Improved IRAs Boost Savings?

3 Will expanded IRAs and the introduction of Roth IRAs boost savings? We believe so, and substantially if the new tax incentives stay in place or get enhanced.the impact of tax incentives on the level of savings has been the subject of much academic controversy. Some analysts say that the original IRAs did little to boost overall savings, and that contributions to IRAs merely represented shifts of assets that would have been saved in other vehicles. Some of these critics note that the overall personal savings rate continued to fall in the early to mid-1980s when IRA contributions were at their peak. Other analysts argue that the contribution from IRAs to new savings is substantial. A more centrist group of researchers has concluded that IRAs produced a meaningful increase in net savings, which, over time, has beneficial consequences for investment and economic growth. Table 1: The U.S. Trails the Other G-7 Countries in Saving Household Savings as a Share of Disposable Income 1991 and United States 6.1% 4.4% Japan 13.2% 11.9% Germany 12.9% 11.4% France 13.2% 12.8% Italy 17.6% 12.9% United Kingdom 10.1% 11.9% Canada 9.9% 4.6% Source: Organization for Economic Co-operation and Development All of the studies on the impact of tax incentives for savings are limited by the fact that the rules governing eligibility for IRAs have been highly erratic. IRAs were established by ERISA in 1974 and limited to workers without employerprovided pension coverage. Tax legislation in 1981 greatly expanded eligibility for IRAs; the Tax Reform Act of 1986 sharply curtailed eligibility. Bottom line: a consistent set of eligibility rules was not in place long enough to draw sound conclusions about the impact of IRAs on savings behavior. Table 2 IRAs After the Taxpayer Relief Act of 1997

4 Who s Eligible Traditional IRAs All taxpayers with earned income who have not reached the year in which they attain age 70 1 /2. Taxpayers covered by an employment-based pension plan can take a deduction for contributions if their income is below certain income thresholds. Deduction is phased out for single filers with modified adjusted gross income (MAGI)* of $30,000-$40,000 and joint filers with MAGI of $50,000- $60,000. Phaseout ranges rise to $50,000- $60,000 by 2005 for single filers, and to $80,000-$100,000 for joint filers by Roth IRAs All taxpayers with earned income, regardless of other pension coverage, with MAGI up to certain limits. Eligibility for contributions is phased out for single filers with MAGI of $95,000- $110,000 and joint filers with MAGI of $150,000 and $160,000. Spousal Contributions Spouses (working and non-working) are generally eligible for equal-sized contributions of up to $2,000 per year. A spouse who is not a participant in an employer-sponsored retirement plan can deduct contributions, even if the other spouse is an active participant. (This special rule is subject to phaseout when MAGI is between $150,000 and $160,000.) Spouses (working and non-working) are generally eligible for equal-sized contributions up to $2000 per year. Maximum $2,000 per year until year $2,000 per year.

5 Contribution** of attaining age 70 1/2. Contributions can continue until death if individual has earned income. Withdrawals Withdrawals can begin at age 59 1 /2 mandatory minimum distributions must begin by April 1 of the calendar year following the year of reaching age 70 1 /2. Certain withdrawals can occur before age 59 1 /2without a 10% penalty tax, such as distributions for qualified education expenses, a first-time home purchase ($10,000 lifetime limit), or certain medical expenses. Tax free withdrawals of earnings can occur after five years if: taxpayer has reached age 59 1 /2, the withdrawals are for a firsttime home purchase ($10,000 lifetime limit), or the withdrawals are related to death or disability. Withdrawals of non- deductible contributions can occur at any time without federal income tax. Tax Treatment Contributions may be tax deductible; withdrawals (not attributable to noncontributions) are treated as ordinary income in the year received. Contributions are not tax deductible. Qualified withdrawals are tax free. Penalties for Early Withdrawals Unless an exception applies, early withdrawals are taxed as regular income; and a 10% penalty is imposed. The taxable portion of an early withdrawal is subject to a 10% penalty tax, unless an exception applies, including certain higher education expenses. (An additional penalty tax may apply in certain situations if the technical corrections bill passes in Congress.)

6 *"Modified Adjusted Gross Income" (MAGI) For a traditional IRA take adjusted gross income (AGI) add any IRA deduction, any foreign earned income exclusion, any foreign housing exclusion or deduction, any adoptionassistance-program exclusion and any interest on U.S. Savings Bonds used to pay higher-education expenses. AGI is identified as such on Form 1040 typically in the last box on page 1 (line 31). MAGI for Roth IRA purposes can be calculated from traditional MAGI by subtracting any deductible IRA contributions and any income resulting from conversion of a traditional IRA to a Roth IRA. **Maximum individual contribution to both types of IRAs combined is $2 000 per year. Source: Taxpayer Relief Act of 1997 But, we do know the following from IRS data. In 1980, the year prior to the Economic Recovery Act of 1981, IRA savings contributions were recorded on 2.6 million tax returns (2.7% of all returns), and the value of contributions totaled $3.4 billion. Those figures jumped sharply after 1981, reaching a peak of 16.2 million returns in 1985 (15.9% of all returns), with contributions totaling $38.2 billion. Compared to 1981 levels, the results through 1985 reflected a $115 billion $148 billion when 1986's contributions are included cumulative increase in new IRA contributions. We discussed this issue at length last year in Assessing the Investment Climate: Focus on Washington 4/7/97, IRAs and the Savings Issue. We expressed the view at that time and continue to maintain that IRAs will generate substantial net new saving, if they are consistent and remain in place for the long haul. Will the post-tra'97 features of IRAs motivate new savings? We believe they will. One key factor is the increase in the number of taxpayers that will be eligible for some type of tax-favored IRA. The Joint Committee on Taxation (JCT) estimated last year that roughly 54% of taxpayers would be eligible under the old rules for the maximum contribution to a deductible IRA for 1997, and that another 13% would be eligible for a partial deduction. The number of taxpayers eligible for a deductible IRA will gradually rise further as the income thresholds determining eligibility rise in accordance with TRA'97. Furthermore, available tax data suggest that well over 90% of taxpayers will be eligible for a Roth IRA contribution. The Employee Benefit Research Institute (EBRI) estimates that if the Roth IRA were in place last year, 99% of single filers and 97% of joint filers would have been eligible. The increase in the IRA-eligible population fits well with the need to raise awareness and encourage individuals to save. We also believe the liberalized withdrawal provisions will have a positive impact. Prior to last year's legislation, any early withdrawals from IRAs were subject

7 to income tax and a 10% penalty tax, with certain exceptions, such as death, disability, and some medical expenses. TRA '97 allows penalty-free early withdrawals from IRAs to finance a first-time home purchase or certain education expenses. Generally, an early withdrawal is one that occurs before age 59 1 /2. Individuals will have even greater access to the funds in their Roth IRAs compared to traditional, deductible IRAs. First, withdrawals of non-deductible contributions can occur at any time without incurring income or penalty taxes. After a Roth IRA has been funded for five years, withdrawals of both contributions and earnings can occur tax-free if certain requirements are met, including reaching age 59 1 /2, withdrawing funds for a first-time home purchase, or if the withdrawal relates to death or disability. There are two schools of thought on whether expanded access to the funds in an IRA before retirement will encourage more retirement savings. Critics argue that the new withdrawal provisions will encourage individuals to use IRAs as a vehicle for other types of savings, and will not contribute to enhanced savings for retirement. But, we believe that individuals will save more for retirement with the assurance of knowing they have access to the funds in the event of a real need. This may be particularly true of younger workers beginning their careers, who still have homeownership and educational expenses ahead of them. The magnitude by which the liberalized withdrawal provisions will result in increased savings is potentially considerable. A look at how savers who have some access to their 401(k) savings before retirement through loan provisions may provide some insight. An October, 1997 General Accounting Office (GAO) study found that when 401(k) plans had loan provisions, workers were more likely to participate in the plan, particularly lower-income workers. In addition, workers made larger contributions, 35% more on average, when their 401(k) plan had loan provisions. Meanwhile, there was no evidence that workers abused the loan provisions; fewer than 8% of participants (at the time of the study) had loans outstanding. Ideally, savings for retirement will be preserved for retirement. In our view, the key question is whether flexibility provisions will prompt some savings to occur that might not have otherwise, regardless of how modest. Early withdrawal provisions for IRAs and loan provisions of 401(k) plans are not perfectly comparable. Still, the GAO study suggests that giving individuals some limited access to their funds before

8 retirement may encourage incremental savings on the part of workers who would have saved less otherwise. Roth Vs. Traditional IRAs Do Roth IRAs provide an advantage over traditional IRAs? That depends on factors that will vary with each taxpayer. For some taxpayers who have employer-sponsored pension coverage, the answer will be relatively simple. They may be eligible to contribute to a Roth IRA, but may not qualify for a deductible contribution to a traditional IRA because of the lower income thresholds (relative to the Roth IRA) that determine eligibility. Taxpayers who are eligible for both deductible and Roth IRAs will have to weigh a long list of variables, including expected future income tax rates compared with present income tax rates. Also, individuals have to weigh whether they think policymakers will change the laws regarding the tax treatment of IRAs. At its simplest, the difference between the two types of IRAs is when the tax benefit occurs. With traditional IRAs, the tax break occurs when deductible contributions are made; with the Roth IRA, the tax benefit takes place when withdrawals are made. In the strictest sense, a traditional, deductible IRA and a Roth IRA will be equally beneficial if identical (tax-adjusted) contributions and investments are made, and tax rates at the time of contribution and the time of withdrawal are equal. Most individuals circumstances are likely to vary from such a rigid scenario. Many taxpayers may anticipate paying a higher income tax rate when they withdraw IRA funds than when they make contributions at the beginning of their careers, which would make the Roth IRA a better bargain. Some workers at the peak of their careers might anticipate a lower tax rate at the time of withdrawal, making a deductible IRA more attractive from a tax perspective. Individuals who expect to have other sources of income in retirement might favor a Roth IRA, since assets could continue to grow past age 70 1 /2. Allowing assets to grow beyond age 70 1 /2 will also appeal to individuals who want to pass their IRA assets on to their heirs. Furthermore, heirs may not have to pay income tax on assets from a Roth IRA (although they would still be subject to estate taxes). Whether individuals expect to pay taxes on their Social Security benefits in retirement would also be a factor to consider. Are there characteristics of the Roth IRA that might encourage new savings, and not just an asset shift from deductible IRAs? We think so.

9 The $2,000 contribution limit for both traditional, deductible and Roth IRAs effectively allows more savings to occur in a Roth IRA. To be strictly comparable to the deductible IRA, a taxpayer in the 28% tax bracket only needs to invest $1440 ($2000 pre-tax) in a Roth IRA. (This comparison assumes an individual chooses only a traditional IRA or a Roth IRA, and does not split the $2,000 maximum contribution between both types of IRAs.) IRS data from the mid-1980s show that about 75% of taxpayers contributing to IRAs made the maximum allowable contribution, regardless of deductibility. That implies, in our view, that many individuals will take full advantage of the provisions of the Roth IRA, without calculating what nondeductible contribution would be comparable to a deductible contribution to a traditional IRA. Something that might keep Roth IRA assets saved longer is the fact that there are no mandated withdrawals. Holders of traditional IRAs are required to begin withdrawing funds by April 1 of the calendar year following the year they reach age 70 1 /2. The EBRI 1997 Retirement Confidence Survey found that 50% of retirees with IRAs withdraw only what is required to avoid tax penalties; older retirees were more likely to fall into this category. It is possible that, even in the absence of mandated distributions, withdrawals from a Roth IRA will be greater since there will be no tax owed on those withdrawals. Conversely, it is possible that some retirees will have other sources of income, and will choose to keep their Roth IRA savings invested. The Challenge: Getting Individuals To Use What's Provided Data suggest that more has to be done to get individuals to take advantage of available savings incentives. Many taxpayers particularly those at lower levels of income don t take advantage of tax incentives to save, like IRAs. (In fact, one study found that a larger percentage of taxpayers in higher income groups contributed to nondeductible IRAs than eligible lower income taxpayers contributed to deductible IRAs.) Table 3: Percent of Eligible Taxpayers Contribution to IRAs in 1985 Adjusted Gross Income Number Reporting IRA Percent of Contributions (in Millions) Eligible Returns Under $10, % $10,000-$30, %

10 $30,000-$50, % $50,000-$75, % $75,000-$100, % Over $100, % All Income Classes % Sources: Joint Committee on Taxation, Internal Revenue Service. Table 3 shows that even when the rules governing IRAs were at their most generous, the overall percentage of eligible taxpayers taking advantage of the IRA deduction was small. More recent data indicate that participation in IRAs among eligible taxpayers has declined further, to below 10%. The falloff in participation since eligibility for deductible IRAs was restricted may be due, in part, to a lack of awareness on the part of some taxpayers that they will qualify for an IRA deduction. Table 4 shows that participation rates are much higher in employer-sponsored 401(k) plans than in IRAs, although many workers still don t participate when their employer offers a plan. Some possible reasons for higher participation in 401(k) plans might include the automatic payroll deduction ( I don t even miss it ), employer contributions toward matching of employee contributions, and employerprovided educational materials about the need to save and guidance in making investment decisions. Table 4: Participation Rates When Employers Offer 401 (k) Plans (1992 Data) Annual Earnings Participation In Employer Sponsored 401 (k)plan Less than $5, % $5,000-$9, % $10,000-$14, % $15,000-$19, % $20,000-$24, % $25,000-$29, % $30,000-$49, % $50, % All Workers 64.9% Source: Employee Benefit Research Institute.

11 The participation rates in 401(k) plans versus IRAs tell us that workers are more likely to save if they have information and if savings vehicles are "user-friendly." Policymakers have made progress on these fronts over the last couple of years, and the momentum exists to accomplish more. The Taxpayer Relief Act of 1997 included provisions that can potentially increase participation in, retirement savings plans. TRA '97 repealed the 15% excise tax on excess distributions (and excess accumulations within an account holder's estate) from qualified retirement plans, including IRAs. The law also permits an increase in the amount that partners and the self-employed can contribute to taxdeferred savings plans. In addition, employers will eventually be able to communicate information about plans to their workers electronically, e.g., through or voice mail. Legislation passed in 1996 was aimed at increasing retirement savings of workers employed by small businesses. Fewer than 25 % of workers at small businesses have pension coverage. The Small Business Job Protection Act (SBJPA) of 1996 established SIMPLE IRAs and 401(k) plans. These plans are available to firms with 100 or fewer employees with no other pension plan; SIMPLE plans are subject to less complex administrative and reporting requirements. In the case of a SIMPLE IRA, employees can make tax-deferred contributions up to $6,000 per year; a partial employer match is required. The $6,000 contribution limit is indexed for inflation. Several members of Congress have sponsored legislation that include additional incentives for small businesses to provide pension plans, including defined benefit plans. One bill, dubbed "Pension Pro-Save," would allow small businesses to provide plans through a national clearinghouse. Other legislation pending in Congress strives to increase pension portability to reflect a more mobile work force; bills have also been introduced that emphasize pension protection for women. President Clinton also offered a number of pension provisions in his fiscal 1999 budget, including a tax credit for small businesses who start plans and a provision for facilitating contributions to IRAs for eligible employees through payroll deductions. Congress may also include further enhancements to IRAs in tax cut legislation that is considered this year. Possible provisions include an increase in the contribution limit, perhaps via inflation indexing, and a "catch-up" provision that would allow individuals to make contributions for prior years in which they were eligible.

12 Like all other items on the legislative agenda this year, measures to provide additional savings incentives will be affected by a short legislative calendar and election year pressures. We think, however, that support for retirement savings initiatives will carry over into the next Congress. The need for public education about the need for savings has been acknowledged by policymakers. The SAVER (Savings Are Vital to Everyone's Retirement) legislation passed last year, mandated a "retirement summit," which will take place at the White House in early June. The SAVER legislation also calls on the Labor Department to step up its education efforts in the mass media. A savings education campaign was also kicked off in late March by a coalition of business, consumer, and government organizations, including the SEC and the American Association of Retired Persons. Conclusion We know there is a savings shortfall in America. The Merrill Lynch Baby Boom Retirement Index underscores the need for more savings. Demographically, except for the 85 and over population, the group age 45 to 64 will be the most rapidly growing group in the U.S. over the next 10 years. And, that group shows a higher propensity to save than either their juniors or their seniors. The age group historically allocates a larger percentage of their household assets to financial assets. Now, with the advent of the Taxpayer Relief Act of 1997 there is a conscious new set of tax-based incentives to save. For many Americans, conversion to a Roth IRA will make great sense. With the tax law incentives, there is a positive new element in the financial planning dynamic. It even has implications for generational wealth transfer. Enhancing savings flows results, ceteris parabis, in equilibrium interest rates being lower than would otherwise be the case. This contributes to greater economic growth. Directionally, we believe Congress and the Administration understand this message. We believe the incentives in the Taxpayer Relief Act of 1997 are meaningful and will be followed by incremental incentives going forward. We feel new tax legislation will emerge to encourage small business to set up defined benefit plans and to allow individuals to contribute to IRAs through payroll deduction. We also see meaningful increases in employer sponsored retirement savings. Copyright 1998 Merrill Lynch, Pierce Fenner and Smith Incorporated (MLPF&S). This report has been issued and

13 approved for publication in the United Kingdom by Merrill Lynch, Pierce, Fenner & Smith Limited, which is regulated by SFA and has been considered and issued in Australia by Merrill Lynch Equities (Australia) Limited (ACN ), a licensed securities dealer under be Australian Corporations Law. The information herein was obtained from various sources, we do not guarantee its accuracy or completeness. Additional information available. Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities or any options, futures or other derivatives related to such securities ("related investments ). MLPF&S and its affiliates may trade for their own accounts as odd-lot dealer, market maker, block positioner, specialist and/or arbitrageur in any securities of this issuer(s) or in related investments, and may be on the opposite side of public orders. MLPF&S, its affiliates, directors. officers, employees and employee benefit programs may have a long or short position in any securities of this issuer(s) or in related investments. MLPF&S or its affiliates may from time to time perform investment banking or other services for, or solicit investment banking or otter business from, any entity mentioned in this report. This research report is prepared for general circulation and is circulated for general information only. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income from such securities, if any, may fluctuate and that each security s price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide to future performance. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related investment mentioned in this report. In addition, investors in securities such as ADRs, whose values are influenced by the currency of the underlying security, effectively assume currency risk.