I have asked before, and am motivated by recent reports to ask again: do you think the income earned on savings accounts should be exempt from income tax regardless of the purpose for which the savings are ultimately spent? I think so, and I’m not alone. I have been seeing reports that this idea has resurfaced, but it still isn’t getting a lot of attention, at least not yet.
A few years ago, legislation was introduced in Congress that would create universal savings accounts (USAs) for American taxpayers. The proposal wasn’t perfect, but it would have created a type of savings account that, unlike existing savings accounts, would earn interest without being subject to income tax, regardless of the purpose for which the savings are ultimately spent. That fits with my suggestion that savings account earnings should be completely exempt from income tax. Under the proposed legislation, contributions to USAs could be invested in bonds and equities (stocks), which would make USAs similar to Coverdell ESAs and Roth IRAs, but without the rules that limit the purposes for which the funds from IRAs and ESAs can be spent.
The talk about tax-advantaged savings accounts has come back amid the ongoing discussions about middle-class tax reform. Whatever you think about those tax reform discussions, it seems pretty clear to me that promoting individual savings is a worthy objective in any federal tax legislation.
Under the federal tax code, there are three common types of savings accounts in which the earnings are exempt from income tax if used for specified purposes: retirement accounts (Roth IRAs), health savings accounts (HSAs), and education savings accounts (Coverdell ESAs and qualified tuition or 529 plans). Each type of tax-advantaged savings vehicle has developed more or less separately with their own, sometimes very complex, rules.
Are there financial objectives other than retirement, medical expenses, and education that merit a tax advantage? What about saving for a down payment on a first house, or long term care expenses for elderly family members?
And if Americans aren’t saving enough in general, as we are repeatedly told, then why shouldn’t there be savings vehicles in which the income earned on the savings is not taxed, regardless of the ultimate use to which the savings are put?
When I’ve addressed those questions previously, I pointed out that I wasn’t talking about some new, outrageous idea, or something I thought up myself. Such savings vehicles already exist in Canada (called tax-free savings accounts, or TFSAs) and Britain (individual savings accounts or ISAs).
The proposed USAs would be another kind of limited tax-exempt savings vehicle, in addition to the ones that already exist, so they wouldn’t do anything for tax simplification. They would, however, encourage saving. Congress has in the past taken small steps toward expanding the range of financial objectives that qualify for tax-advantaged savings, by adding new purposes for which money in education savings accounts and Roth IRAs may be withdrawn without tax consequences. For example, some expenses incurred in buying your first home can qualify for tax free withdrawals from your Roth IRA. Withdrawals from a Coverdell ESA or a 529 plan for technology purchases can likewise qualify for tax-free treatment.
If tax-free savings accounts must be limited, it would help if Congress standardized the rules for the different types of such accounts, instead of having separate, often quite complex, rules for each type. That would at least make the tax treatment of savings a little simpler.
The proposed addition of USAs to the menu of existing tax-advantaged savings vehicles, while being a step in the right direction, would make the taxation of income on savings even more complex by creating yet another type of account with its own rules. Why not create a general-purpose savings account, with relatively high limits, the earnings from which will be completely tax-exempt, to encourage saving?
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Nathan B. Hannah is a Shareholder in the Tucson office, and practices in the areas of estate planning and administration, real estate, and commercial transactions. He is also a noted blogger, and you can find more of his articles on his private blog,
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