Ten years from now, the introduction of the individual retirement account (IRA) as a universal saving tool will be hailed as the most significant achievement of the Reagan "revolution." Until the Economic Recovery Tax Act of 1981, millions of Americans were ineligible to set up their own retirement programs, outside of company plans. Now they are not only eligible but are enthusiastically encouraged—by both the government and the financial business community—to participate. Indications are that IRAs are becoming extremely popular. And no wonder—the IRA provides several dramatic benefits.
First, an IRA can reduce current taxable income by $2,000, or $4,000 for a working couple. This is one of the few tax breaks available for people earning less than $20,000 a year. And it is available to everyone who works for a living. Even Social Security recipients can earn $2,000 and shelter it in an IRA without losing Social Security benefits. The $2,000 deduction is available even to people who already have a corporate or government pension plan or a self-directed Keogh.
A second advantage of the IRA is that it encourages savings. This year alone it is estimated that new IRAs will put $30 billion into savings, money that probably would not have been saved otherwise or would have gone to the government; and the amount will increase substantially in 1983. As a result of the universal IRA, the savings rate in the United States is expected to climb from a paltry 5 percent to over 6 percent this year, an increase of nearly 25 percent. Higher rates are expected in the future, as Americans return to the habit of saving.
For years the US government's policy has discouraged saving and investing by taxing interest, dividends, and capital gains at high rates, while offering tax deductions for interest expenditures on consumer items. Moreover, the tax rate for consumption purchases (sales tax, for example) is extremely low compared to the tax on investment income. The United States is gradually reversing this policy—especially through reductions in long-term capital-gains rates and, more recently, through the introduction of tax-deferred IRAs.
This higher savings rate is essential to future economic growth, as the Japanese, German, and other high-growth economies have demonstrated. The Keynesian prescription for economic prosperity—that is, the push toward higher consumption levels—has not worked.
Austrian economic theory, as articulated by Ludwig von Mises, Friedrich A. Hayek, and Murray N. Rothbard, has shown that a high rate of savings, not consumption, is the key to economic prosperity. In fact, Austrian theory supports the view that increasing the savings rate increases production, eventually resulting in a higher total consumption level. The Keynesian theory of reducing savings rates and increasing consumption rates has just the opposite result—slower economic growth and less consumption in the future.
A third—and perhaps the most significant—benefit is that the IRA provides a retirement program superior to the Social Security system. In fact, the universal IRA promises to be a natural replacement for the bankrupt Social Security program. Under the current set-up, Social Security alone will push America into hyperinflation unless it is replaced soon with a sound pension system.
Originally established to provide supplemental retirement income at a time when the average life span was 61 years, Social Security has become, in many cases, the only source of income for retirees who are living longer and retiring earlier. Adjusted to the cost of living, Social Security benefits are increasing rapidly. Medicare and Medicaid, added to supplement "inadequate" benefits, place a mammoth burden on the already-broke system.
It is important to realize that Social Security is not a bona fide pension program. A true pension plan takes the money invested by workers and keeps it in a trust fund that makes longterm investments. Through wise management, compounding of interest, and tax deferral, a worker's original savings multiply until, by retirement, he has amassed enough money to live comfortably the rest of his life.
Social Security benefits are paid in just the opposite manner. Money is paid to current beneficiaries the minute it is received. There is no long-term investing of funds. Moreover, benefits are essentially unrelated to how much you put into the program. A person who has paid into the system a minimum 10 years (40 quarters) qualifies for the same monthly payments as someone who has paid into the program all his working life. And with proponents now talking of borrowing from general funds to pay for Social Security, it is no wonder that younger workers are concluding in increasing numbers that by retirement age there will be nothing left for them except a mountain of debt.
Social Security, like other federal welfare schemes, began with an extremely low budget. In 1937, workers and employers paid a mere 1 percent each on a maximum of $1,000 of income. Since then it has grown into a monster. In 1982, both employer and employee will pay 6.7 percent on all income up to $32,400. This means that the average worker will pay over $1,000 in Social Security, or FICA (Federal Insurance Contributions Act), taxes this year. Considering that the employer must contribute an equal amount, the actual "contribution" comes to over $2,000. Self-employed individuals pay a current rate of 9.35 percent on $32,400, or a maximum tax of over $3,000 this year!
The maximum amount of income that is taxed for Social Security—now $32,400—is tied to the cost of living, so that as wages increase, FICA liabilities increase. If current figures aren't staggering enough, consider the fact that just 10 years from now it is estimated that a worker earning $60,000 a year will pay 15 percent of his income to Social Security, amounting to $9,000!
How can this madness be stopped? So far, all efforts to reduce benefits have been stalemated by a Congress overly sensitive to the retirement community. Retirees represent the largest voting bloc in the country, and as long as benefits are linked to the cost of living, this influential group of constituents will bring little pressure on Congress to lower the inflation rate.
Meanwhile, there are increasing efforts to boost the revenues used to pay for Social Security. Some advocates call for making the program mandatory for all workers—including federal employees, who currently enjoy the benefits of a separate, well-run pension plan, and the employees of state and local governments and nonprofit groups that in many cases have taken advantage of their option not to participate in the system. Others advocate imposing a tax on earnings above the current maximum income base of $32,400, a soak-the-rich scheme that would require employers and employees to pay a percentage of total income. This would increase tax liabilities without increasing benefits.
Several years ago a presidential candidate suggested that Social Security be made voluntary for workers under 40 years of age. This seems like a good start. The old system could be phased out gradually, without harming those who are already approaching retirement, and replaced by far-superior private pension programs that have already proven their success.
Any alternative pension plan, however, should not be made mandatory. That's one of the chief stumbling blocks with Social Security—people are being forced to enter a long-term savings program that ignores their current needs. True, those who don't plan ahead might find themselves unable to retire when they want to, but the freedom to fail is just as important as the freedom to succeed. It is when people are allowed the widest possible choices about how to spend and save their money that they can make decisions appropriate to their individual circumstances.
While mandatory pension plans are objectionable, tax-incentive programs such as Keoghs or IRAs have much to recommend them. Contributions to these funds are tax-deductible, and earnings within the pension program are tax-free until they are withdrawn, providing a strong motivation to save. There is also a penalty for withdrawing money before retirement, which encourages long-term savings. Significantly, you are not required by law to participate.
The principle of tax-favored private pension plans is now well established and is already providing a supplement to Social Security. Efforts should be made to allow these pension plans to replace Social Security before it reaches total bankruptcy. This is the only real solution to the massive welfare dilemma we're facing in this country.
So much for the theory. How about practical advice on how to maximize your profits in an IRA? Let me offer the following recommendations.
1. Set up a payroll-deduction program where you work or an automatic-withdrawal plan with your bank. This is an extremely convenient and painless way to save and will keep you from slipping off the wagon before saving has become a personal habit. It's tough to come up with $2,000 at tax time, but a monthly withholding program will make it a lot easier. Many IRA trustees can arrange this kind of withholding program.
2. Decide what your retirement goal is. You can use your IRA for earning a safe, conservative return, or you can be a speculator who trades the market. Many people feel uncomfortable trading or speculating in an IRA, so for them, it might be best to stay with money market funds or perhaps gold mutual funds as a long-term inflation hedge. But remember, if you put long-term inflation hedges in your IRA, you lose the tax advantages of long-term capital-gains rates (which are 60-percent tax-free), because IRA withdrawals are taxed at ordinary income rates. It makes the most sense, then, to use your IRA for dividend or interest income or for short-term trading. Whatever your goal is, be your own money manager and use a self-directed IRA.
3. Use a mutual-fund family for maximum flexibility and lowest cost. No-load mutual funds charge no commissions, so 100 percent of your money goes to work. Most offer a toll-free number, which allows you to switch from one fund to another at no charge. Flexibility is the key to investing in this uncertain economic climate. You want a family fund that offers trading in stocks, bonds, money markets, and gold shares. A full list of funds can be obtained for $1 from the No-load Mutual Fund Association, Valley Forge, PA 19481.
IRAs are the wave of the future. It is very likely they will be expanded in the future, and all of us can hope for the day they will replace Social Security. Start early, and you'll have a real nest egg for your retirement. Tax-free compounding can have dramatic results.
Mark Skousen is a financial writer, economist, and author of the new book Tax Free: All the Legal Ways to Be Exempt from Federal, State, and Social Security Taxes.
This article originally appeared in print under the headline "How Do You Spell Relief? I-R-A".