What are Universal Savings Accounts and Why Are They Important?

September 11, 2018

Yesterday, a series of bills dubbed “Tax Reform 2.0” was introduced by Chairman Kevin Brady (R-TX) to build upon last year’s reforms to the tax code. The second bill in the series, the Family Savings Act of 2018 (H.R. 6757), would make several improvements to the way the tax code treats personal saving. This includes the introduction of a new savings vehicle, called universal savings accounts (USAs), which would in part fix the issue of double taxation of saving.

Most people instinctively think that they shouldn’t have to pay taxes on the interest they earn from their savings, and that feeling is correct. A neutral tax system would tax each dollar of income only once. And, after all, when we save our income, we’ve already paid income taxes on it.

But currently our tax system is not neutral. A dollar of income can face up to four layers of tax in some cases: 1) it’s taxed when you earn it and pay income taxes; 2) it’s taxed when a business you invest in earns a profit and pays business income taxes; 3) it’s taxed when you realize returns to investment and pay taxes on capital gains and dividends; and 4) it’s taxed when you pass away or give it as a gift through estate and gift taxes.

This simple example illustrates why multiple layers of taxation are problematic.

Suppose all income is taxed at a 10 percent rate. Under a traditional-style, tax-neutral system, if I make $100 and put it into a savings account, I don’t owe income tax on it yet. (Here it counts as income at the point of consumption, and by saving it I am not consuming it.) Suppose I leave it in the savings account for one year and it grows to $110; I make a 10 percent return. When I withdraw it, I owe a 10 percent tax, or $11, meaning I end up with $99.

Now suppose, under a different tax system, I owe the 10 percent tax up front, meaning I have $90 to put in my savings account. After one year at the same rate of return, I have $99. If the example stopped here, we wouldn’t have a problem—the tax would still be neutral, and I would still end up with $99 (this is Roth-style treatment). But if it doesn’t stop here, when I withdraw the $99 I would again owe the 10 percent income tax, meaning I end up with just $91.

Multiple layers of tax reduce the return to saving, thereby encouraging immediate consumption rather than saving.

This is troubling for several reasons. It artificially lowers the return to saving, making saving less beneficial for our personal financial health and making immediate consumption more attractive. And, whether we set our money aside in a savings account at a bank or invest it in stocks or bonds, our savings fuels economic growth because it supports investment. If the tax code discourages saving, it can have a negative impact on investment and growth.

Now, the tax code offers reprieve from this bias by offering tax-neutral savings accounts. Neutrality is achieved in one of the two ways described above. Traditional-style allows the saver to defer income taxes on the amount they save and pay taxes when they take distributions from the account. Roth-style does the opposite; savers still pay income taxes on the amount they save, but when they take distributions, they are exempt from income taxes. This neutrality is limited, though, by numerous rules and restrictions that govern these accounts, making the tax structure of long-term saving complex and biased.

This is where universal savings accounts come in. If you’re familiar with 401(k)s or Individual Retirement Accounts (IRAs), then you’re close to knowing what USAs are.

The USAs proposed in Tax Reform 2.0 would allow individuals to save up to $2,500 each year in a Roth-style savings account, which could be opened at places like banks or other qualified administrators. However, unlike retirement savings vehicles, which are laden with restrictions on who can save and when or why the money can be used, there are no income limits for who can contribute to USAs, and the money invested could be withdrawn at any time and used for any purpose. This means individuals can use USAs to buy a car, make a down payment on a home, cover unexpected expenses, or any variety of purposes.

Universal savings accounts fix the issue of double taxation, providing ideal tax treatment for all purposes instead of just for government-favored purposes like retirement. They would allow folks to save for any of life’s expenses without being subjected to the burden of double taxation. Congress could improve on the current proposal by increasing the contribution limit to allow tax-neutral treatment for all saving. The USAs proposed in the Family Savings Act of 2018 are a welcome improvement to the tax treatment of personal saving.

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