April 21, 2013

A budget proposal earlier this month raised the possibility of limiting the total amount that can be saved in TSP accounts, along with other tax-preferred accounts such as Individual Retirement Accounts (IRAs) and Health Savings Accounts (HSAs).

One of the original, guiding principles of tax-preferred accounts such as the TSP (and including others such as 401(k)s, 403(b)s, and IRAs) is that workers should have the ability to save and invest some of their wages in ways in which wages are taxed only once. For traditional TSP accounts, the amount is saved and invested with pre-tax income that is taxed only when it is withdrawn many decades later. For Roth TSP accounts, the amount is saved and invested after paying tax, but when withdrawn many decades later there will be no additional taxes owed on that amount.

It is easy to forget that Congress and the White House can propose a variety of legislation at any time to change any or all of these features.

This is bound to be the case especially as long-time participants build significant wealth in tax-preferred accounts, which is arguably one of the goals of these tax-advantaged programs. (Greater independent wealth means less dependence on taxpayer-funded programs such as Social Security, Medicare, and eroding pensions.) Stories of people with many millions of dollars in their 401(k)s and TSP accounts will attract particular attention. This will be especially the case with future Roth Millionaires, whose wealth will be tax-free upon withdrawal.

In an era of huge and endemic deficits, these stories will highlight the massive pools of untaxed funds that continue to grow in a tax-preferred way through the years. The TSP alone has grown to over $350 billion in assets in its short 25-year history, for example. How many billions in revenue would that generate if it were taxed? The same is true for other tax-advantaged accounts. According to Pensions and Investments Online, 401(k)s held $3.29 trillion in assets as of mid-year 2012. Again, that is a massive amount that is left untaxed until it is withdrawn, or never taxed at all in the case of Roth accounts.

These plans will thus face greater political pressure to limit their tax-preferred nature to increase tax revenue coming into the treasury.

Indeed, one recent budget proposal for 2014 does just that. The proposal, which was made just over a week ago, states quite emphatically that it seeks to “Prohibit Individuals from Accumulating Over $3 Million in Tax-Preferred Retirement Accounts” (italics in the original). The rationale is as follows:

“Individual Retirement Accounts and other tax-preferred savings vehicles are intended to help middle class families save for retirement. But under current rules, some wealthy individuals are able to accumulate many millions of dollars in these accounts, substantially more than is needed to fund reasonable levels of retirement saving. The Budget would limit an individual’s total balance across tax-preferred accounts to an amount sufficient to finance an annuity of not more than $205,000 per year in retirement, or about $3 million for someone retiring in 2013. This proposal would raise $9 billion over 10 years.” (The original proposal can be found here on page 18.)

Notice that the way this proposal is written, if enacted it would limit both regular and Roth TSP accounts as well as traditional and Roth IRAs to which feds and uniformed personnel can contribute as well. The proposal is also specifically cumulative, so that individual savers and investors could not accumulate more than $3 million in all of these vehicles combined. So TSP investors who also save and invest in an IRA and an HSA would face an upper limit when all of these accounts together equal the upper limit.

This is not the only type of legislative challenge to tax-preferred savings vehicles such as the TSP. Future Congresses can enact – and future presidents can sign into law – measures that would limit or effectively tax these funds through other means:

1) Limit the total amount that is tax-advantaged in each of these accounts, as proposed above.

2) Enact a national consumption tax or Value-Added Tax (VAT). Any sort of national consumption tax would require savers to pay additional taxes on products and services they buy, even if they use funds from previously taxed Roth accounts.

3) Abolish parts or entire forms of tax-preferred savings vehicles, such as the Roth option for each of these vehicles.

It is particularly ironic that this proposal is being made during “Financial Literacy Month.” I guess the ultimate message is that we should “save, but not too much…” I still need to be educated, though, as to why it is bad that “individuals are able to accumulate many millions of dollars in these accounts.”

Related topics: tsp-updates hsa