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Want tax reform? Exempt “deferred tax liability” retirement accounts.

I keep reading about the tax reform Congress and the President keep talking about, but all I really seem to see is proposals to ease business tax and increase tariffs, which may or may not put the economic blender on puree (as PJ O’Rourke once famously wrote).  Tariffs generally are a bad idea, but if judiciously applied in areas where other countries (cough, CHINA, cough) are dumping goods into our market below cost, then I’m cautiously for them.  Overall, though, tariffs are usually idiotic, as is taxing the income of expatrirate American corporations and individuals.  Repatriating dollars honestly earned and already taxed by foreign governments should not initiate further taxation by the FedGov.

But this has nothing to do with you and me in the middle class, groaning under the weight of income taxes free American citizens never had to pay until 1913.

I read yesterday that Social Security is now on track to run out of money by 2028.  Which is significantly sooner than what we were being told a few years ago, variously 2034 or 2045 depending on what politician was making mouth noises.  Not that anyone can actually live on a Social Security check, but I digress.

This got me to thinking about retirement accounts.  You know, 401(k)s, 403(b)s, Roth IRAs, etc.  All of these accounts are funded by pre-tax deductions from your earnings.  In the case of 401(k)s and 403(b)s, generally this is involuntary on your part — if you work for a company that offers one, you’re in the program, whether you contribute or not, because the company will contribute some minimum amount even if you don’t.  Generally it’s considered stupid not to contribute to these funds, at least up to the company’s “match”, which might be 3% or 5%, or might be some weird construction like “company matches to 3%, then matches half to 5%”, meaning that if you contribute 5%, the company will contribute 4%.  Whatever.

The point is that these are tax-deferred accounts.  That means you have to pay tax on them eventually — just not right now, so there is actually incentive to participate (same with a company insurance plan, if you’re lucky enough to have one in the era of Obamacare, since anything you pay for insurance comes out pre-tax).  So, OK, when do you pay that tax?

Why, at the point when you can least afford it — when you retire and start taking distributions from your retirement account.  And possibly worse, you pay the then-prevailing tax rate for such things, which might be higher than it was when you first started throwing money into the account.  So if between now and several years from now when I hope to retire, if Congress suddenly decides to start taxing retiree accounts at 50%, I’m screwed.  (And so are you.)

In the meantime, your retirement “savings” (generally, investments in mutual funds, which in turn are made up of shares of corporate stock) are subject to the vagaries of the market.  I had a tidy sum in my 401(k) in 2008.  After the crash, I had lost half the dollar value of the account.  Which, at first blush, sounds awful, but as my investment advisor reminded me, I still had all of the fund shares I’d purchased, and with stock prices then in the toilet, it was time to buy.  And historically, the market has always come back.  Which of course it has, and since I was buying 401(k) shares every two weeks (and increased my contribution to the maximum the company would match), the value of my 401(k) has more than doubled since then (particularly since the election, of course).

More than fixing the individual income tax, fucked up as it is, what would really make me sit up and take notice would be if Mr. Trump would come out for permanently exempting post-retirement distributions from any market-based retirement account that contains less than (say, for the point of argument) $5 million from being taxed.

That said, there should be the following restrictions:

  • If you take money out before you retire minimum retirement age, you pay income tax on what you take out.  [Edited a bit to better indicate what I meant.]
  • If you borrow money from your retirement account that you have to pay back, you can’t deduct the interest (and if you don’t pay it back, you pay income tax on it).
  • If you take more than the maximum allowable distribution in any given tax year, you pay income tax on the overage.  That said, the maximum allowable distribution should be generous, probably on the order of $50,000/year per person in today’s dollars.*  That means that a couple like my wife and myself, IF we had that kind of money in our 401(k)s (we don’t), could get along pretty well after retirement.

Also said, the government would have the following responsibilities:

  • If a retirement account contains more than the suggested $5 million maximum when its owner retires, income tax is paid on distributions taken only until the account drops below the $5 million threshold.
  • The baseline threshold at inception would be subject to increase or decrease annually, based on inflation/deflation as reported by the CPI.
  • The exemption from taxation of retirement accounts would be permanent, all future Congresses would be bound by it, and there would be a provision to shoot or hang any Congressman or Senator who proposed or voted for the re-institution of income tax on retirement account distributions.  And yes, I am serious about the last bit.

In other words, because you risked your money on a gamble that the stock market would continue to rise, and because you thereby contributed to the growth of the economy, you should get a pass on paying taxes on that money if you follow the rules and use it properly for your retirement.

Come on, Mr. Trump.  Be bold.  Throw this out there and dare Congress to ignore it.

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* I believe this differs from the current program, where after you’re 59-1/2, there is no limit on distributions, you just have to pay income tax on whatever you take.