Over at the tax law blog Start Making Sense, Daniel Shaviro shares the inside scoop from one of his informants:
[T]he Bush “tax reform” plan is likely to have three main elements: (1) make the tax cuts permanent, (2) fix the alternative minimum tax problem, and (3) enact enlarged (say, $7,500 per person per year) Roth IRA style tax-free savings accounts, including large incentives to convert from existing IRAs, 401(k) plans, and the like that were deductible up front.
The first one is no big surprise, and neither is the second one. Number three isn’t too new either, except for that “large incentives to convert” twist.
With traditional IRAs and 401(k) plans, you can deposit untaxed money that is taxed when you withdraw it later in life. With Roth IRAs, you deposit money that has already been taxed, and then when you withdraw it later, it’s tax-free.
So there’s this pool of money out there in traditional IRAs and 401(k) accounts that is due to be taxed sometime but hasn’t been taxed yet. If the Dubya Squad can come up with some way to convince people to let him tax it now instead of later, he can have more of our money to play with today without having to actually raise taxes. This follows the Dubya Squad modus operandi of spending freely today and sticking tomorrow with the bill.
Pretty sneaky, eh? How are they going to do this? Carrot or stick. Probably carrot — they might give a discount on the tax people pay when they transfer funds from a traditional IRA or 401(k) to a Roth or Roth-like IRA.
Here’s an example of how someone might be convinced to transfer their money from a tax-deferred account to a taxed account — I did it last year: In , I earned about $18,000. I ran the numbers and determined that I could have earned as much as $25,000 and still be under the federal income tax line. So I transferred $6,500 from my traditional IRA to a Roth IRA. That $6,500 is considered part of my income for (I left some wiggle room: $18,000 + $6,500 = $24,500).
This sort of transfer is legal, and there’s no penalty (as there would be if I just withdrew the money from the traditional IRA rather than transferring it to a Roth IRA) — but I do have to pay the tax on that $6,500 now instead of later. However, I pay that tax at my current rate of taxation, which, because my total income is so low, is 0%. So that $6,500 went from being money that I was due to be taxed on eventually to being money that was never taxed and never will be. (Although if the people who want to replace the federal income tax with a federal sales tax get their way, all that careful planning on my part will be wasted.)
This sort of transfer is sensible not only for those of us with a little space in our 0% zone, but for anyone who thinks that they’ll be in a higher income tax bracket when they retire than they are today. Of course, this is just guesswork, but in a case like mine where today’s rate is 0%, it’s a no-risk no-brainer. Depending on the incentives that the Dubya Squad tax reform plan offers in the future, though, this option may come to make more sense to even more tax resisters.