HAVE you set up a Roth IRA yet? If you haven't, it can't be for lack of marketing effort by the financial services industry. Since Jan. 1, when the new tax-free savings accounts became available, every other piece of junk mail at my house has been a Roth IRA come-on. The personal-finance magazines are filled with articles about this "revolutionary" way to save.
Permit me to rain a little skepticism on the revolution. I have no idea whether the Roth IRA is the appropriate savings vehicle for you and your family -- as they say in Money magazine. I do, however, doubt that this tasty new tax break will accomplish any meaningful public policy objective. Indeed, there are only two things we can say for sure about the Roth IRA's economic impact. First, it is going to cost the U.S. Treasury $20 billion over the next 10 years (according to the Joint Committee on Taxation). And, second, the vast majority of this subsidy will wind up in the pockets of high-income Americans.
Like a "traditional" IRA, all interest, dividends, or capital gains earned on the $2,000 per year you're allowed to invest in a Roth IRA accumulate (and compound) tax free. But, whereas you must pay taxes when you cash in your traditional IRA at the age of 59 1/2 , all withdrawals from the Roth IRA are tax free. Also, in a Roth IRA, you can keep your money in as long as you want after you turn 59 1/2 , so it keeps on compounding tax free. (A traditional IRA requires you to cash out at 70 1/2 -- no pun intended.) After your Roth IRA is 5 years old, you may withdraw money to pay for college or for catastrophic medical expenses, or even to make a $10,000 down payment on a first home -- again, tax and penalty free.
In a recent interview published on the Fidelity Investments website (where else?), Sen. William Roth, the Delaware Republican who invented this sweet deal, promised that the Roth IRA would lead to a "tremendous" increase in the U.S. savings rate -- something he called "critical" to our economic future. But, judging by the promotional literature from Fidelity, Charles Schwab, and the rest, Mr. Roth has wildly oversold the impact of his new IRA on savings. The financial services industry's biggest push is not to enlist new IRA savers but rather to "convert" the $1.3 trillion worth of savings currently tied up in traditional IRAs to the more lucrative Roth IRAs. To the extent they succeed, the country's pool of savings won't grow; it will just slosh around from place to place.
Which is more or less what happened with traditional IRAs. Generally speaking, IRAs give people a tax break for engaging in economic behavior they would have found rational anyway: i.e., putting money away for retirement. As former Federal Reserve Chairman Paul Volcker once observed: "If you give people a tax-exempt way to save, they will choose the tax-exempt way instead of the taxable way, but it doesn't seem to do much for the overall savings rate."
The U.S. savings rate was 9.4 percent of Gross National Product in 1981, when the IRA was introduced. It is less than 4 percent today. You can say savings would have been even lower without the IRA. But you can't say the IRA "revolutionized" anything. Moreover, when the government gave up billions of dollars in tax revenues to establish IRAs, it had to replace the lost cash by raising taxes on other economic activity or by borrowing. That is, it had to dip into the pool of savings that would otherwise have been available for the private sector. Now, thanks to the Roth IRA, the government will have to raid the private economy for another $20 billion over the next decade.
As Money decorously puts it: The Roth IRA is "most appropriate for the young and affluent." It's a boon for the rich for two reasons. First, all tax deductions benefit the rich disproportionately because, the higher your tax bracket, the bigger your tax cut. Second, because it is a tax break for savings, the Roth IRA benefits most those who have extra money to save. In theory, it's available to all income classes. In practice, the paycheck-to-paycheck crowd need not apply.
The Roth IRA also suffers from a confusion of policy objectives. Is the purpose of the new law to encourage savings, as the senator told Fidelity's website? Or is it, as he said in the same interview, to "encourage particularly your younger citizens to buy homes" -- as if middle-class home-buying weren't already heavily subsidized by federal tax policy? Or does the Roth IRA's provisions for tax-free medical and college tuition savings make it a prototype of the medical and tuition savings accounts (a version of which just passed the Senate) that Republicans tout as a substitute for Medicare and student loans? Combined with the recent capital gains cuts, these new tax-free savings vehicles are putting the country on a slippery slope toward an income tax system that affects only wages and salaries. This would be highly regressive, since the rich receive the vast majority of non-wage income -- interest, dividends, and capital gains.
Of course, the biggest winners from the Roth IRA are financial services firms, estate planners, accountants and everyone else who makes a living advising people how to keep the government away from their money. Indeed, the Roth IRA adds so much complexity to the tax code that even the smartest investors will probably need to pay for professional advice. (My favorite Roth IRA gimmick is the $9.95 "IRA Analyzer" cd-rom from T. Rowe Price.)
And what's all the fuss about savings anyway? In his interview with Fidelity, Sen. Roth tried to raise the old Japan bugaboo as a justification for the Roth IRA. "We're now in a global economy," he warned. "Japan has tremendous savings. Admittedly, right now they're having some difficult problems, but they'll come back." But, if anything, Japan may be having "difficult problems" -- namely, economic meltdown -- because of its national mania for savings, not in spite of it. Japanese business has made huge "misinvestments" partly because savings were so abundant -- and therefore cheap -- that there was little incentive to use them wisely. In this sense, the low U.S. savings rate may actually enhance the performance of the private economy. Or so the current American boom, fueled by low interest rates, would seem to suggest.
It's pointless to use the tax code to shift savings from one corner of the economy to the other. Government can best encourage private sector efficiency by drawing up rules that treat all forms of economic activity -- and all forms of income -- equally. Once government establishes a level playing field, the marketplace will work its magic, allocating resources according to the real demands of households and firms, as opposed to the preferences of politicians.
Charles Lane is a senior editor of The New Republic magazine in which this article first appeared.
Pub Date: 5/04/98