As the politics of the reconciliation bill get messier by the day, new data is shining light on the financial standing of Americans and how the economy is impacting them. According to a recent survey by Vanguard, more Americans are tapping into their retirement accounts for emergency expenses, such as covering medical bills and preventing foreclosure or eviction. In one sense, it is great to see that Americans have access to retirement accounts for emergencies and that they are accumulating wealth in these accounts, but it is also important to remember to keep these accounts intact for a stable financial future and to encourage individuals to continue saving in complementary accounts for a rainy day or to accomplish whatever savings goals they may have.
The tax treatment and tweaks to retirement accounts, such as automatic enrollment, is helping tax advantaged accounts grow and should be a lesson for future tax legislation: the tax code should be structured to encourage individuals to put savings ahead of the consumption decision. But our current tax code taxes income when it is earned and then again when that income is reinvested and earns a return. In addition, the tax code also suffers from various complexities, like different tax treatment for similar investments. For example, the tax treatment of bonds depends on the issuer, whether it is federal, municipal or corporate, while the capital gains tax rate on corporate stocks depends on the length of time the stock was held.
Not only do different savings vehicles have different rules, limitations, and tax consequences, but also new products are continuously launched in the financial marketplace, providing different options and tax strategies for people trying to save for various purposes. Sometimes these differences can be overwhelming and may paralyze individuals trying to choose what investment vehicle to use or leads them to overinvest in one type of product or simply choose to consume rather than save.
A great example is mutual funds, a type of investment that pools money from many investors to buy a diversified portfolio of stocks, bonds, or other securities. If these funds are held in taxable accounts (outside the tax advantaged savings vehicles) they could incur yearly taxes for the mutual fund investor if investment vehicles are sold at a profit within the fund, even if the proceeds are reinvested. The same mutual fund within a tax deferred account like a 401k, on the other hand, would defer the taxes until the investor is ready to sell those funds. In the long run, the investor might end up with a different pool of savings, despite the fact that the same amount of money was invested, thanks to the compounding effect of taxes.
In fact, the tax consequences of inside activity for mutual funds impacts investor behavior. According to a National Bureau of Economic Research study, “Taxable investors who are considering purchasing fund shares around distribution dates have an incentive to delay their purchase until after the distribution, since this will reduce the present value of their tax liability. Non-taxable shareholders, such as those who invest through IRAs and other tax-deferred accounts, face no such incentive for delaying purchase.” The planning for the tax consequences of savings adds one more layer of complexity for investors. If the earnings are reinvested, savers should be encouraged to keep that money in the fund by deferring the tax payment on realized gains. Unexpected tax bills at year end might lead some account holders to liquidate their savings if they are cash strapped, putting a strain on savings.
Recently Michael Faulkender, the number two Treasury official highlighted this same exact issue. At a US Chamber Capital Markets summit on June 3 he said “The way I've always understood capital gains is it should be deferred until realized, and if I buy a mutual fund and I don't engage in a transaction why am I incurring a capital gains tax. Capital gains should be deferred until it is realized versus when the fund does a rebalancing. Other investment products do this and there needs to be some congruence there. We need to get this done.”
The Deputy Secretary is not alone in his thinking: Sen. Cornyn and his counterparts in the House, Representatives Terri Sewell and Beth Van Duyne, introduced a bill called the GROWTH Act. If enacted, the bill could keep as much as $16 billion in savers pockets that is currently being taxed as this phantom tax, because the fund is never sold and the capital gains distributions are reinvested. Sen. Cornyn understands how unfair this is and is seeking a long-overdue fix.
The merit of this idea is simple, as Senator Cornyn said when he introduced the bill, saying the bill aims to “empower hardworking Texans to let their money work longer, build toward personal savings and retirement goals, and create generational wealth.” These are all noteworthy efforts to encourage savings to complement money accumulating in retirement accounts.
The tax code should be built on three goals: simple, fair and pro-growth. Unfortunately, we keep building on our existing code, increasing complexity for U.S. taxpayers. At this point, it might be unrealistic to expect a complete overhaul of the tax system, but we could focus on saving and investment provisions that decrease the tax burden in order to fuel capital formation.
