Obama’s Budget Would Cap Tax-Advantaged Savings

Some of us have worried for decades that when America’s tax-advantaged savings pot got large enough, our perpetually revenue-challenged federal government would raid the nest egg. All that untaxed growth would simply prove irresistible.

That day may be at hand. President Obama’s budget, just sent to Congress, proposes to cap tax-advantaged savings across all accounts at $3 million in order to raise $9 billion over 10 years.

The proposal is being spun as a way to prevent wealthy private-equity executives from amassing huge IRAs—like Mitt Romney’s, once estimated to be worth as much as $100 million. But it would also curb the savings ability of self-employed professionals like doctors and lawyers. As these business owners reach the cap, and there’s nothing left in it for them, they might shut down or reduce plans that benefit their employees.

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The cap proposal is a clear play to unlock some of the $10 trillion sitting in IRA and 401(k) accounts, which have become the primary retirement savings vehicles in America. Congress pried this door open a few months ago by toying with a law forcing heirs to liquidate an IRA within five years—almost certainly triggering otherwise avoidable income-tax payments. We may see that yet.

Now the president is wedging the door open further with a proposal that targets the wealthy. This is how it starts. What’s next? Taxing the growth in Roth IRAs?

Social Security benefits were once sacred and unencumbered. That began to change about 30 years ago; today roughly 85% of Social Security recipients pay some kind of income tax. The attack has not let up. The president’s new budget seeks to cut future Social Security benefit increases by tweaking the inflation formula.

Now lawmakers are moving on to the next bucket of cash. It’s not clear how the IRA cap would be enforced. Would savings beyond $3 million be disallowed? Or taxed right away? If you already have more than $3 million in IRA and 401(k) accounts, might you be forced to take immediate taxable distributions? Would Roth IRAs and traditional pensions be included under the cap? Hopefully, the budget will provide some answers.

The $3 million cutoff is itself something of a mystery. The White House reasons that $3 million is enough to provide an annual annuity of $205,000, which it further reasons is plenty income for any retiree. Yet there’s a lot wrong with this line of thinking.

Start with the mathematical assumption that $3 million can reliably generate $205,000 of annual income for a couple for 30 years or more of retirement. This calculation assumes a Herculean low-risk annual return of 7% at a time when Treasury bonds yield less than 2%. Don’t try this at home.

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Insurers will underwrite additional risk to give you a higher guaranteed rate of return. But they won’t go as far as the president would like to you believe. According to immediateannuities.com, a 65-year-old couple with $3 million can purchase an immediate, single-premium annuity that will pay $170,316 a year until the second one dies. This is taxable income, by the way. Is $110,000 or so a year, after all taxes are paid, really plenty income at a time in life when health costs can be astronomical? It’s not bad. Don’t get me wrong. But it’s not rich.

Let’s not shed too many tears for the wealthy professionals who can amass $3 million in an IRA. They’ll be fine. The thing to worry about is the kind of slow creep that continues to degrade Social Security benefits. Is the door to our tax-favored nest eggs one we really want to open?