Roth IRA “Conversion” Gimmick May be Used to Mask the True Cost of New Tax Cut Package Nearing Adoption by Congress

May 5, 2006. Press release below; also, links to additional resources.

Roth IRA “Conversion” Gimmick May be Used to Mask the True Cost of New Tax Cut Package Nearing Adoption by Congress

As news reports of the last several days have indicated, the chairs of the Senate Finance Committee and the House Ways and Means Committee have reached an “agreement in principle” on a tax reconciliation bill that would include approximately $70 billion of tax-cut extensions including a two-year extension of the dividends and capital gains tax rate cuts, which don’t expire until 2008, and a one-year adjustment in the Alternative Minimum Tax to prevent more middle-class Americans from being hit by the tax.

Not as widely reported, however, is the likely use in this tax cut package of a gimmick that would increase federal tax revenues temporarily to help “offset” the cost of the capital gains and dividends tax cuts in 2011 through 2015. If not offset, these costs would violate a Senate budget rule, subjecting the reconciliation bill to a 60-vote point of order. After raising revenues for a few years, however, the gimmick would substantially reduce federal revenues after 2015 and increase deficits in the long term.

The gimmick involves the removal (for a temporary period of time) of the income limits on who can convert traditional Individual Retirement Accounts (IRAs) to Roth IRAs. Congressional and independent budget analysts agree that this change would spur a large number of high-income households to convert their traditional IRAs to Roth IRAs in order to take advantage of the long-term Roth IRA tax breaks. This, in turn, would lead to an increase in revenues over the 2011-2015 period, because people converting a traditional IRA to a Roth IRA would pay taxes in that period on the amount being converted. But it also would reduce
revenues in years beyond 2015 when withdrawals from the new Roth IRAs would be made and would be tax free. This is essentially a timing shift that accelerates into the 2011-2015 period revenues that otherwise would be collected in subsequent years.

Moreover, over the long run, the proposal would result in a net reduction in tax revenues. People would elect to convert their traditional IRAs to Roth IRAs only if doing so would be to their advantage because it would lower their tax bills. In other words, they would elect to pay some additional taxes now only if they expected that it would reduce their tax bills by larger amounts in the future. Anyone who expects that such a transaction would increase his or her tax bill simply would not covert a traditional IRA to a Roth IRA.

This gimmick, in effect, allows the Congress to use one tax cut (i.e., increasing the income limit on Roth IRA “conversions”) that only benefits higher income Americans to pay for other tax cuts (i.e., the extension of lower capital gains and dividend rates) that overwhelmingly benefit the wealthy.

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Links to additional materials on this issue

A.  Distributional analyses from the Urban-Brookings Tax Policy Center:

Possible Major Individual Income Tax Provisions in 2006 Tax Reconciliation Bill Fully-Phased In Impact at 2006 Income Levels, Distribution of Federal Tax Change by Cash Income Percentile

Possible Major Individual Income Tax Provisions in 2006 Tax Reconciliation Bill Fully-Phased In Impact at 2006 Income Levels, Distribution of Federal Tax Change by Cash Income Class

IRA Conversion Provision Fully-Phased In Impact at 2006 Income Levels, Distribution of Federal Tax Change by Cash Income Percentile

IRA Conversion Provision Fully-Phased In Impact at 2006 Income Levels, Distribution of Federal Tax Change by Cash Income Class

B.  Analyses from the Center on Budget and Policy Priorities:

Reconciliation Tax Cuts Would Average $42,000 for Households With Income Over $1 Million, But Only $20 for Middle-Income Households

Joint Tax Committee Estimate Shows That Tax Gimmick Being Designed to Evade Senate Budget Rules Would Increase Long-Term Deficits: Approach Would Add New Tax Cuts to “Pay For” Other Tax Cuts