Would Universal Savings Accounts cannibalize retirement plan contributions?

In the coming days, Rep. Kevin Brady, R-TX, chair of the House Ways and Means Committee, is expected to circulate a discussion draft of a Tax Reform 2.0 bill with an eye to advancing a floor vote in the House this September.

The bill is expected to include a provision creating Universal Savings Accounts, which would allow any American age 18 or older to invest after-tax dollars that could grow tax-free and be withdrawn for any purpose, at any time, without penalties.

Details of the proposal are scant, but previous companion legislation, last introduced in 2017 by Sen. Jeff Flake, R-AZ, and Rep. Dave Brat, R-VA, set the contribution limit at $5,500 annually, which would be adjusted for inflation.

The Universal Savings Account Act would serve as a “supercharged IRA,” said Rep. Brat in a statement when he first introduced the bill in 2015.

Sen. Flake noted that existing tax law incentivizes savings for retirement, education, and health care while “disincentivizing” saving for other needs.

The origin of USAs can be traced at least as for back as President Clinton’s administration, which proposed that budget surpluses—when they once occurred—could be used to help fund the accounts for lower wage earners.

More recently, the National Association of Insurance and Financial Advisors threw its support behind the Flake-Brat bill, as did think tanks The Cato Institute and the Mercatus Center, and Americans for Tax Reform, a lobby group.

A primary design of the accounts is to address Americans’ inability to cover short-term financial shocks. Flake and Brat cited data claiming only 53 percent of adults can cover an emergency expense of $400 with selling assets or borrowing money.

Larger macro theories also motivate support for USAs among conservatives. “Congress ought to be empowering individuals – not the federal government – to decide how to manage their savings, and it should start by establishing these tax-free USA Accounts,” said Flake in 2015. The accounts eliminate existing “tax-bias” and would allow savers the freedom to decide how and when to spend their own money.

Cannibalizing retirement savings?

When the idea for USAs was floated in the 1990s, actuaries raised some concern that the accounts could have the unintended consequence of cannibalizing employer-provided retirement plans.

“Probably the biggest concern is that the USA proposal could discourage employers from sponsoring pension plans,” said a policy brief from the American Academy of Actuaries at the time.

Initial concern that USAs would hurt sponsorship and deferrals to 401(k) plans was allayed when the Clinton administration proposed savings in USAs could be rolled into 401(k)s.

Fast-forward a couple of decades, and the prospect of USAs is again raising questions as to whether they would inadvertently crowd out savings in qualified retirement plans.

“In theory, USAs are a good idea,” said Barbara Van Zomeren, senior vice president at Ascensus, a leading recordkeeper for small and midsized employer-sponsored retirement plans.

USAs could be an effective tool to reduce leakage from retirement accounts, said Van Zomeren. Leakage from early withdrawals and defaulted loans from defined contribution plans results in as much as $6 billion in lost retirement savings annually, according to one estimate.

But if Congress were to design USAs with limited restrictions, the result could be reduced deferrals to retirement accounts.

“If the rules on USAs are liberal, and savers are allowed to contribute to them before contributions to a Roth IRA or 401(k), then there could be concern that savers couldn’t afford contributions to both, which could lead to reduced retirement savings,” she said.

The Flake-Brat bill places no restrictions on contributions to USAs relative to the timing of contributions to IRAs and 401(k)s.

“The hope is that lawmakers are ironing out the details at this point with the goal of balancing emergency savings needs with the need for prolonged savings for retirement,” said Van Zomeren.

Versions north of the border, across the pond

Canada and the United Kingdom already have a version of USAs—Individual Savings Accounts, or ISAs, in the U.K., introduced in 1999, and Tax-Free Savings Accounts, or TFSAs, in Canada, introduced in 2009.

Both allow penalty-free withdrawals for any need. The U.K. version allows the equivalent of $25,000 of annual contributions; the Canadian version caps annual contributions at $4,125, which can be rolled forward if the threshold is not met. Both programs are based on after-tax contributions. Neither have the income restrictions of Roth IRAs.

In Canada, 54 percent of adults have opened an account, according to analysis by the Cato Institute. About two-thirds are making annual contributions at an average of $4,719 U.S. dollars.

In the U.K., 43 percent of adults have opened an account, with 58 percent of them making annual contributions at an average of $7,923 U.S. dollars.

Utilization in both cases far outstrips contributions Roth IRAs, which are held by only 20 percent of adults in the U.S. About a quarter make annual contributions, the average amount being $4,164.

Wage earners of modest means are utilizing the accounts in the U.K; about 55 percent of all account holders have an annual income of less than $25,000 U.S. dollars.

An election season gambit?

Tax Reform 2.0 could quite conceivably pass out of the House of Representatives, but it is unlikely to get through the Senate, which would required a 60 vote majority.

The crux of the House initiative is extending the cuts to the individual tax rates passed last December in the Tax Cuts and Jobs Act. The new individual rates are scheduled to sunset at the end of 2025.

Whether or not USAs and other savings and retirement proposals being considered in the House will be incorporated in one tax bill, or separate from making the lower individual tax rates permanent, is not known, said Ascensus’ Van Zomeren.

Inquiries to Rep. Brady’s staff as to whether the House will propose separate provisions have not been returned.