Clear Fog Blog

Political musings from Warren E. Peterson

A Debt Ceiling Revenue Solution

Posted by Warren Peterson on July 25, 2011

An estimated total of $8.1 Trillion is currently held in IRA and 401K plans. This may not include 401K style plans available to government employees and the self-employed. I did not find a breakout for traditional (put in pre tax dollars and pay regular income tax on withdrawals) versus Roth (put in after tax dollars but pay no tax on gains) plans but it is probably safe to assume the largest amount is in the tax deferred traditional IRA plans.

These funds may offer the debt ceiling warriors a way to increase revenue to keep the Democrats happy but without raising taxes, keeping the Republicans happy. By repealing the traditional 401K/IRA plans but keeping the Roth IRA, dollars contributed to 401K/IRAs would be taxed thus increasing revenue. Taxpayer income for living expenses (food, housing, transportation, leisure etc.) would remain the same. Only the savings investment dollars would be reduced due to taxes. However, the net investment money could be put into a tax free Roth IRA which in the long run is probably a better investment. A one time good deal could be offered to people holding investments in 401K/IRA tax deferred plans to convert to a Roth style plan by paying a low flat tax (immediate revenue to the government) on the transferred funds. Most people would have to sell some of their investments held inside their 401K/IRA accounts to cover taxes. Therefore conversion would have to be spread over several years so as not to disrupt the markets. Some may choose not to convert due to factors such as life expectancy.

The end results are: more cash to the government for the short-term, no living expense cash flow effect for the taxpayer, no change in tax rates except for the special conversion tax, no fear of the IRS or Congress grabbing your Roth retirement income.

This proposal still leaves open the questions of spending reductions, balanced budget amendments and tax reform but it does get us past the current impasse on revenue. The other issues can be settled November 6, 2012.

Cross posted on Sound Politics

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6 Responses to “A Debt Ceiling Revenue Solution”

  1. Gramps said

    Colonel Peterson…Sir!
    I’m beginning to appreciate the compass and depth of your thoughts on a more regular basis.

    So called…”thinking outside the box” has always been characteristic of famous and successful military leaders throughout the ages.

    Might I add…some rare, politicians also…

  2. I agree that the Roth will probably be the best protection against a debt ceiling tax grab. Since it’s funded with after-tax dollars it would hardly be appropriate to tax it. In addition, since Roths are still relatively low, the amount of money built up in them is relatively small compared to more traditional retirement programs. There just wouldn’t be much tax revenue to be had there.

    One other point–there’s a lot of talk about the government looking to retirement accounts to raise revenue, but we can’t forget that they’ve become an important part of the nations capital base. Taxing them would not only reduce that base but also act as a disincentive for anyone to participate. If the government takes this step they’ll be hurting the country and the citizenry in ways that cannot be fully measured. We have to hope that enough people in congress are aware of this that they don’t go ahead with it.

  3. Fredc said

    I would like to point out a big technical difficulty with this proposal: millions of retirees no longer receive monthly paychecks, and they received their defined benefit pensions in a lump sum at the time of retirement as a traditional IRA. Virtually all of their non-Social Security retirement is, and has been for many years, invested in these accounts that are not taxed until withdrawal and are the funds they live on day-to-day. I understand your proposal is to tax these accounts, worth $8 trillion now, as regular income?

    How could a solid conservative Republican propose such a thing as a one-time involuntary TAX (!!!) of $2-3 Trillion? This is a stake in the heart of the middle managers and small mom and pop businesses who pay taxes as ordinary income and for years have relied on the tax-free appreciation of their 401(k)s and IRAs for their retirement. You would now say, “Sorry, those IRA/401(k) retirement accounts, and the terms of tax-free appreciation we promised you 40+ years ago, will now be taxed, now, at ordinary income rates, to pay down this debt the Republicans have built up since 2001, leaving you with 65-70% of the total to live on.” You cannot be serious. Many of these people took paper losses of 25-35% with the 2008 recession and have still not recovered, and as if that is not enough, your government would ask for 30-35% more to pay for the deficit? Come on.

    • Fred,

      You missed the point. Under this proposal, people could still invest after tax money in a Roth IRA which eliminates taxes on appreciation. Employers could still match but the match would be taxed at the time it was put into the Roth IRA. Canceling the tax deferred plans restores the revenue stream to the goverment immediately rather than having it wait for the mandatory distributions starting at the year following age seventy and a half. For people who have money in a traditional tax deferred IRA or 401K, they could keep the money there or convert to a Roth by paying a small flat tax collected over several years. If one is young enough where the tax free Roth works out to out perform the tax deferred plan, or one is concerned about future tax rates, or you are retired or close to it and the one time flat conversion tax is lower or close to the tax one pays on required distributions (which is the ordinary tax rates in effect at the time), you may want to consider converting. A surprise for those in the first year of required distributions is there are two withdrawals payable in the first year you reach 71. One for the year you turned 70.5 payable by March of year 71 and another in December for year 71. The result is one pay taxes on two years of distributions in year 71. Two years of distributions in the same tax year exposes more of your money to your highest marginal tax rate. This is not a concern if you are with drawing funds from a Roth IRA because there is no required distribution and no tax on any withdrawal.

      My suggestion does bring future tax revenue back to current years but if it is truly used to pay down the debt or help phase in balanced budgets, it is worth considering. It would also cut the funds available for spending by future Congresses.

  4. Fredc said

    Yeah, I did miss the point, because I don’t think you have made one that would convince holders of IRAs and 401(k)s that this is a revenue-neutral, or better, solution for them. There are many questions that are unanswered.

    Answer the questions of Mr Jones, who retired in the late 90’s from Motorola after 30 years, accumulating $200,000 in his 401(k), and he has seen it appreciate to a value of $400,000, in spite of the 2001 tech bubble loss and the 2008 recession. He and his wife planned their retirement income based on a conservative withdrawal (4-5% annually) from the 401(k) to augment their social security payments. Tell your fans how and when you would tax the current principle amount of $400,000, and explain how that would be a good deal for the Jones family.

    Should we take this off line?

    • Off line is fine for further discussion but just to consider your example of Mr. and Mrs. Jones, thanks to the Democrats, 85% of their Social Security benefits wii be taxed as ordinary income if their total income is over $33,000. Let’s say the Jones’ joint gross income is $36,000 ($16,000 from IRA plus $20,000 from SS). Their adjusted gross income will be $33,000 ($16,000 plus .85 X $20,000). Assuming they take the standard deduction of $11,400 plus the personal deduction of $7,300, Their taxable income will be $14,300 ($33,000 less $18,700 in deductions). Thanks to the Bush tax cuts, they will only have to pay $1,430 (10% tax bracket zero to $17,000). So in this case they would not want to opt for a Roth conversion. But add in pension and other investment income putting them in the 15% tax bracket, any flat conversion tax rate under 15% might make converting to a Roth a consideration.

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