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As I'm sure many of you may be aware of by now, the budget that President Obama is expected to announce on Wednesday comes with an explicit change to retirement accounts. Namely, the budget calls for a wealth cap on certain accounts. Per Business Week:

Obama's budget plan, to be unveiled April 10, would prohibit taxpayers from accumulating more than $3 million in an individual retirement account. That proposal would generate $9 billion in revenue for the Treasury over the next decade, according to a White House statement released today.

"Under current rules, some wealthy individuals are able to accumulate many millions of dollars in these accounts, substantially more than is needed to fund reasonable levels of retirement saving," the statement said.

More specifically, it is not $3 million in assets that President Obama's proposal would specifically ban, but rather, the amount of money that a retirement account could produce. As The Hill reports:

Under the plan, a taxpayer's tax-preferred retirement account, like an IRA, could not finance more than $205,000 per year of retirement - or right around $3 million this year.

First of all, the politics of a retirement cap may prove to be an example of bad optics leading to bad policy. If a retirement cap should come to pass, the story would be somewhat reminiscent of the history behind the alternative minimum tax. In 1968 and 1968, Treasury Secretary Joseph Barr went around waving the names of 155 high net-worth American citizens that had structured their assets in such way that they had an effective 0% tax rate. That is how we got the alternative minimum tax. The alternative minimum tax was originally designed to go after these 155 taxpayers, and over time, it came to affect middle-class taxpayers with more modest incomes (it was not indexed to inflation, and that is why Congress began enacting "patches" for the alternative minimum tax).

A similar storyline is happening here. The optics of Mitt Romney's IRA with $100 million in it may have provided the political motivation to include this proposal in the budget, in much the same way that Secretary Barr's list of 155 millionaires not paying federal taxes provided the political impetus to pass the alternative minimum tax in 1969. If the alternative minimum tax is any guide, then the focus on "fixing a problem" affecting a narrow subset of taxpayers may have unanticipated effects on future taxpayers over time.

Secondly, the introduction of most new taxation serves the purpose of the government "getting its foot in the door" for future tax increases. The history of OASI taxes (more popularly known as "Social Security taxes") provides the most analogous comparison in this case. When President Roosevelt ushered in the tax in 1937, the Social Security tax rate was 1.00%. It increased to 2% in the 1950s. Then Congress increased it to 3% in the 1960s. By 1978, it crossed the 5% threshold, and gradually peaking to the 6.20% rate that prevails today. If a retirement cap gets passed, it may follow a similar template. Right now, it may be capped at $205,000 in annual income, but the die may be cast for future limitations on income generated from retirement account.

If government officials are bothered by investors having too much money in their accounts, then they should maintain a focus on limiting the amount of money that can be contributed to an account each year (something that the government already does). A problem with imposing caps on retirement account income is that it may penalize particularly intelligent stock selections from a prudent middle-class investor. If an investor had bought $30,000 worth of Johnson & Johnson (NYSE:JNJ) stock in 1980, he would have crossed the $3 million mark over a year ago from that purchase alone. If a 25 year-old investor in 1970 had bought $20,000 worth of Procter & Gamble (NYSE:PG) in a retirement account, he would have crossed the $3 million mark. And if he made the granddaddy investment of them all, buying Altria (NYSE:MO) in 1970, he could have turned just $2,000 into over $3 million worth of Altria, Philip Morris International (NYSE:PM), Kraft (NASDAQ:KRFT), and Mondelez (NASDAQ:MDLZ). An intelligent middle-class investor that buys strong blue-chip stocks and holds for 30-40 years would face cap restrictions should President Obama's plan come to pass.

When we talk about placing caps on something like retirement accounts, we often speak of the "rich" as a static class that changes little with time. But as Dr. Thomas Stanley, the author of The Millionaire Next Door, points out, over 90% of millionaires in this country are self-made. Additionally, it is a narrow window of time through which self-made millionaires enjoy that status. Dr. Thomas Stanley points out that it usually takes a business owner 15-25 years on average to reach millionaire status, and from there, they may have 10-30 years to enjoy the wealth depending on the specifics of their situation (how long they live, how long it took them to become millionaires, etc.). The moral dilemma with posing this $3 million cap on retirement accounts is that, at a time when there is a retirement crisis for most American citizens, we would be electing to punish through taxation the investors that live below their means, delay gratification, and engage in the act of setting aside funds today for a better tomorrow.

There is also reason to believe that this proposal would not generate the $9 billion in revenue envisioned by the Obama Administration. When New Jersey passed its millionaire tax increase, the budget calculations assumed that the present incomes of the New Jersey millionaires would remain stagnant. Of course, what actually happened is that enough New Jersey millionaires altered their behavior and changed their primary residences, causing the New Jersey state government to actually bring in less revenue than before the tax increase passed. Incentives matter, and most folks modify their behavior when the risks/rewards of a situation change.

Perhaps the most troubling element of this announcement is the statement from the White House that $205,000 in annual income constitutes a "reasonable retirement." Generally, Americans prefer the autonomy to determine for themselves what constitutes a reasonable retirement. The fact that the White House is explicitly defining the amount of money that you should find "reasonable" may be troubling, either because you may presently disagree with their definition of reasonableness or you may disagree with it if they should modify the definition of "reasonable income" to a lower amount in years hence.

This should definitely be something worth keeping an eye on as budget talks continue. One of the bedrock assumptions of many Seeking Alpha articles and retirement planning decisions is that tax-deferred accounts come with the protections already promised and guaranteed by the government. This latest proposal from President Obama's Administration attempts to alter those assumptions by capping the annual retirement income at a maximum of $205,000 per year. For the reasons outlined above, this could bring about negative consequences for retirement investors and taxpaying citizens if this proposal comes to fruition.

Source: This New Budget Proposal May Limit Your Annual Retirement Income