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June 23, 2003

How 401Ks are Bankrupting US

Forget Bush's cuts in tax rates or even the cuts in dividend taxes-- those are short-term and can be reversed relatively easily by a future progressive administration -- it's worth remembering that the top rate of 28% pushed through in 1986 was rapidly pushed to over 40% by 1993.

But the real scary action from the 2001 tax cut were the expansions of 401Ks. "Tax-deferred savings" are costing the government big money. How much. Read this story from the Wall Street Journal.:

Tax deferrals amount to $3 trillion of the $11 trillion. That is, if the deposits in these accounts had been saved and invested without tax preferences, and the interest, dividends and capital gains earned and reinvested in these accounts had been subject to income tax, the federal government would have taken in an extra $3 trillion -- an amount that happens to be fairly close to the entire national debt held by the public. In almost every year since 1980, the annual addition to deferred taxes has exceeded the federal deficit.
The dollar amounts are scary enough, but the politics are worse. Conservatives are looking for the fight over taxation of these accounts in retirement to shore up anti-tax politics:
the enormous size of the accumulated balances and the vast numbers of households holding tax-deferred assets will add a third side to the future political economy of budget policy. The first side is the huge weight of Social Security, Medicare and other spending programs benefiting baby boomers and requiring higher payroll and income taxes. The second side is the younger workers resisting those taxes. The new third side is the retirees also seeking lower tax rates in order to retain as much of their retirement savings as possible.

Many people now contemplating a comfortable retirement will be shocked at the bite that federal taxation will take from their benefits and distributions.

"This could manifest itself in greatly increased support for tax reform that lowers rates or retrospectively indexes the definition of income, as well as more narrowly focused relief from the taxes on the withdrawals," former Michael Boskin says (Boskin was the chairman of the Council of Economic Advisers during the first Bush administration).

But the politics gets even nastier as you move towards the new "Roth 401Ks" that will allow tax-free distributions, not just in retirement, but to heirs. As I wrote here:
The new rules allow owners of these Roth 401K fortunes to not only pass them on tax-free to children and grandchildren, but allow those beneficiaries to continue accumulating and spending money from the Roth accounts free of income tax. Imagine a Roth 401K owner in twenty years with $1 million in his account at death; he leaves $100,000 to each of ten grandchildren. Under the exponential math of compound interest, those grandchildren could each enjoy by some estimates as much as $50-100 million of tax-free income over their lives from these Roth 401K bequests.

Not only does this threaten the bankrupting of funding for government services in the future, but the 401K system will create a whole privileged class of wealthy heirs living in a special tax-free world all their own.

So watch the tax-free retirement account politics. They will define the real politics of inequality in coming decades.

Posted by Nathan at June 23, 2003 03:36 PM