The new law offers you a menu of rewards for saving money. What’s driving commentators nuts are all the rules - the phase-outs, cutoffs and subordinate clauses. Rightly seen, however, these limits are more than a weird display of congressional compromise. They’re stop-loss mechanisms that, with luck, will keep the cuts from exploding into a major budget drain.
That was the risk that scared Secretary of the Treasury Robert Rubin. His nightmare was the tax-cutting frenzy of 1981, which, by 1986, was costing 6.3 percent of the nation’s gross domestic product. This time, the revenue loss works out to just 0.2 percent of GDP in 2002 - inconsequential in fiscal terms, Rubin says.
Aim to please: The big cuts are aimed exactly at the voters the pols most want to please. Thanks to the credits for children and education, for example, the tax paid by families making $35,000 to $75,000 could drop by 15 to 75 percent when the changes all take effect. The largest percentage drops will be at the lower end of the income range. High earners with taxable capital gains might see their total bills slashed by 20 percent.
The tax cuts allotted to everyone else don’t amount to much - maybe 1 or 2 percent. The capital-gains cut, for example, won’t reach many middle-class investors. They tend to own their mutual funds in retirement plans, which are taxed at ordinary income rates.
And take the provision that ends the tax for most of the people who sell homes. What tax? Almost everybody defers it. Only 4 percent of each year’s home sellers actually pay on their capital gains, the Treasury says. Now, there’s no obligation at all except for singles with net profits exceeding $250,000, couples whose profits top $500,000 and anyone selling a vacation home. (There’s one shining spot of simplification here. Most of us will no longer have to keep track of the cost of home improvements. That used to be needed to minimize the tax.)
The investment creating most of the buzz is the new Roth IRA, named, by strange coincidence, for the chair of the Senate Finance Committee, Sen. William Roth Jr. (I’m circulating a petition to stop Congress from putting politicos’ names on anything other than bridges and roads.) For now, the Roth IRA seems to do no fiscal harm. But it’s going to be hugely popular - perhaps undermining Rubin’s rule that tax cuts shouldn’t drive the deficit up.
Roth IRAs take effect next year, and whether to bite is a no-brainer. If you qualify, just say yes. You can put away up to $2,000 annually after tax ($4,000 per couple), hold for five years, then never pay a nickel of tax on the money you earn - if it’s spent on your first house (a $10,000 limit); used after you reach 59i or become disabled, or is paid out when you die. It also offers tremendous flexibility for emergency use, says the tax-information firm CCH in Riverwoods, Ill. You’re allowed to withdraw a sum equal to your contribution - at any time and for any purpose - entirely tax-free.
You get a full Roth IRA if you’re single, and your adjusted gross income doesn’t exceed $95,000, or married, up to $150,000. (Eligibility phases out at $110,000 and $160,000, respectively.) You might lose these IRAs when the turn of the screw forces taxes up again. So grab one now and hope to be grandfathered in.
Your alternative is the existing tax-deductible IRA, taxable when the money comes out. The new law improves it, but not enough. For long-term savers, the value of tax-free compounding in Roths (a name even worse in the plural) makes upfront write-offs look trivial, says Peter Elinsky of KPMG Peat Marwick. Roths even look smarter than 401(k)s in plans where employers don’t add to the money you put in.
Cheap college: You’re also allowed $500 a year in an education IRA (blessedly, there’s no vanity name) opened for a child under 18. You put in the money after tax, but get back the earnings tax-free for higher education. Assuming you earn 5 percent in the bank for the first five years, then 9 percent in stocks for the following decade, you’ll have, um, a tax-free $15,000 for college in 2012. A cheap college (in 2012, four years in a public college is expected to cost about $107,000). This fund also lowers your child’s eligibility for student aid, although savers still come out ahead, says Grant Thornton’s Tom Ochsenschlager. The phaseout for contributions from singles starts at $95,000, and for couples at $150,000.
You can’t fund an education IRA in any year you contribute to a prepaid tuition plan, now offered by 14 states. Taxwise, IRAs are better. But you can put more money into tuition plans and, unlike IRAs, they always match the rise in in-state college costs.
One loser under the tax law is the variable annuity. Retirement annuities are OK; I’m speaking of the kind that you can’t tax-deduct. They let you buy stocks and accumulate profits tax-deferred, but you have to pay regular taxes on money you take out.
Compared with paying today’s low capital-gains rates, that doesn’t look so hot. Even a low-cost annuity, bought at 45, has to be held some 20 years to equal the after-tax return you’d get from a comparable mutual fund, says Steve Norwitz of the fund and annuity company T. Rowe Price (Price offers free software comparing the two - call 800-341-0790). The higher-cost annuities sold by insurance agents will almost never pay, except as a hedge against future tax-rate increases.
Banks, brokers and mutual funds will all be offering Roths. They couldn’t be sweeter by any other name.
