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Rescuing Social Security: Personal Retirement Accounts

Copyright © 2004, 2005 by David E. Ross

Above is a list of just some of the tax-sheltered retirement accounts available under current law. The total list is bewildering. Worse, each has its own rules covering:

• eligibility,
• tax treatment of money invested into the account,
• tax treatment of money withdrawn from the account,
• maximum annual amount that can be invested,
• minimum age for withdrawals,
• tax penalties for withdrawing before the minimum age,
• mandatory withdrawals,
• transfers from or to other types of retirement accounts,
• for what purpose the money can be used other than retirement,

  and

• what happens if you die while money is still left.

This confusion must be ended. I propose there be only three kinds of tax-sheltered retirement plans, all designated as Personal Retirement Accounts (PRAs): Pre-Tax PRAs, Post-Tax PRAs, and Employment PRAs. All three would share common rules.

Eligibility

Anyone 18 years old who has not yet begun receiving Social Security benefits would be eligible to create or add investments to any of the three plans. There would be no cutoff of eligibility based on some maximum income threshold. A PRA could not be created or receive additional investments for a person who is already receiving Social Security benefits.

Maximum annual amount that can be invested into PRAs

The combined annual amount that could be added to a person's PRAs — across all PRAs — could not exceed 20% of adjusted gross income (AGI) with an absolute limit of not more than $20,000 (adjusted annually for inflation). This is substantially more than currently allowed for IRAs and more than allowed for 401(k) plans but less than allowed for SEP IRAs and Keoghs. For an Employment PRA, an additional amount — the employer's matching contribution — would be allowed, not to exceed the employee's contribution.

Note that individuals with more than one type of PRA would have to monitor their combined annual investments in all of them.

With a rate of return of 8.5% (the long-term yield of the overall stock market), a person who invests $20,000 per year starting at age 30 and ending at age 65 would accumulate over $4,100,000, which would then yield over $350,000 per year without reducing the principal. Thus, the $20,000 limit is generous even for self-employed individuals with high incomes.

If the maximum is exceeded, there should be a tax penalty of 5% of the excess. Additionally, the excess must be withdrawn from an affected PRA within one year, which might then be taxable income. Withdrawals from a Post-Tax PRA to correct the excess (not taxable income) cannot exceed the amount invested in that Post-Tax PRA in the year the excess occurred. That is, you could not over-invest in a Pre-Tax PRA and then compensate by withdrawing from a Post-Tax PRA.

Tax treatment of money invested into a PRA

For Pre-Tax and Employment PRAs, the AGI would be reduced by the amount invested, equivalent to current IRAs and 401(k) plans. For a Post-Tax PRA, taxable income would not be affected by investments, equivalent to current Roth IRAs. Earnings on all three types of PRAs would remain tax-free while still held in the accounts.

Note that investments in Pre-Tax and Employment PRAs effectively — by reducing the AGI — reduce the accumulation of Social Security benefits. This is why there is a limit on such investments.

Tax treatment of money withdrawn from a PRA

For Pre-Tax and Employment PRAs, withdrawals would be taxed as ordinary income, equivalent to current IRAs and 401(k) plans. For a Post-Tax PRA, withdrawals would be tax-free, equivalent to current Roth IRAs.

There is no capital gains treatment for an increase in the value of a PRA investment. There is no deduction of any kind for a loss in the value.

Allowed investments

Funds in a PRA could be invested in stocks and bonds (including commercial paper and other short-term debts) traded publicly in the United States; in mutual funds regulated by the Securities and Exchange Commission; and in deposit accounts (including CDs) at banks, credit unions, and other federally regulated financial institutions. Prohibited investments would include "closed" corporations, collectables, unregulated hedge funds and venture capital funds, and real estate (except for publicly traded REITs and corporations investing in real estate). Additional permitted and prohibited investments apply to Employment PRAs.

Minimum age for withdrawals

A person could begin withdrawing from a PRA without any tax penalty in the year he or she reaches the age of 60 or one month after the start of Social Security benefits, whichever is sooner.

Tax penalties for withdrawing before the minimum age

Before the age of 55, the penalty would be 20% of the amount withdrawn. From age 55 until withdrawals could be made without penalty, the penalty would be 10%. For Pre-Tax and Employment PRAs, the penalty is in addition to the fact that the withdrawn amount is taxable income.

Mandatory withdrawals

There would be no mandatory withdrawals at any age while the individual is still alive. Taxes forgone on Pre-Tax and Employment PRAs would be levied on mandatory withdrawals by the individual's PRA beneficiaries.

Transfers from or to other types of retirement accounts

The only allowed transfers between PRAs — between PRAs of the same type or between different types of PRAs — would be trustee-to-trustee. No transfer would count towards the maximum annual amount that can be invested into PRAs.

• With an employer's permission, there would be no restrictions on transfers in either direction between Pre-Tax and Employment PRAs.
• Transfers directly between Post-Tax and Employment PRAs in either direction would be prohibited.
• Transfers from a Pre-Tax PRA to a Post-Tax PRA would result in the amount transferred being taxable income, but no tax penalty would result even if the individual were below the minimum age for withdrawals. There would be no limit on the amounts transferred or the number of transfers.
• Transfers from a Post-Tax PRA to a Pre-Tax PRA would be treated as new investments in the Pre-Tax PRA, with a corresponding reduction in AGI and the accumulation of Social Security benefits. In any year, such transfers would limited to not more than 10% of the individual's AGI.

For a married couple, transfers from one spouse's Pre-Tax PRA to the other spouse's Pre-Tax PRA would be unrestricted as would be transfers from one spouse's Post-Tax PRA to the other spouse's Post-Tax PRA. To the extent permitted by their employers, such transfers from one spouse's Employment PRA to the other spouse's Employment PRA would also be unrestricted. This would apply only while both spouses are still living. This also would also apply in the case of divorce when a court decree directs the division of PRAs as part of the division of marital property.

For what purpose can the money be used other than retirement?

These are retirement accounts. The money can be used only for that purpose. Loans and hardship withdrawals from PRAs would be prohibited. However, a PRA would be fully protected from personal bankruptcy as it could not be used to satisfy creditors' claims (at least until the owner makes a standard withdrawal).

What happens if you die while money is still left in a PRA?

Pre-Tax and Employment PRAs are paid into Inherited PRAs (IPRAs) for the PRA beneficiaries. Through withdrawals, an IPRA must be closed within ten years of the death of the original PRA owner, with not less than 5% of the original amount in the IPRA withdrawn each year. Earnings within an IPRA accumulate without being taxed. Withdrawals from an IPRA are taxed as ordinary income. New investments into an IPRA would be prohibited, and multiple IRPAs from inheriting multiple PRAs could not be combined.

Post-Tax PRAs are closed with the amounts paid tax-free to the PRA beneficiaries.

Personal Retirement Accounts: Individual Characteristics

Pre-Tax PRA

In general, this would be the same as a current "conventional" IRA.

• Money invested in a Pre-Tax PRA is deducted from income before computing income taxes.
• Earnings in a Pre-Tax PRA are not taxed as long as they remain within the account.
• Money withdrawn from a Pre-Tax PRA is taxed as ordinary income.
• The owner of a Pre-Tax PRA can direct the investments within certain limits regarding types of investments.

Post-Tax PRA

In general, this would be the same as a current Roth IRA.

• Money invested in a Post-Tax PRA is not deducted from income before computing income taxes.
• Earnings in a Post-Tax PRA are not taxed as long as they remain within the account.
• Money withdrawn from a Post-Tax PRA is not taxed.
• The owner of a Post-Tax PRA can direct the investments within certain limits regarding types of investments.

Employment PRA

While this would be very similar to a 401(k) plan, there would also be some significant differences, prompted by abuses that have actually occurred.

• Money invested in an Employment PRA is deducted from income before computing income taxes.
• Earnings in an Employment PRA are not taxed as long as they remain within the account.
• Money withdrawn from an Employment PRA is taxed as ordinary income.
• An employee could enroll in the PRA after one year of employment (or less, at the employer's option). This would apply uniformly to both full-time and part-time employees, to both hourly and salaried employees.
• Funds withheld from an employee's pay for the Employment PRA must be invested within 30 days. Any employer contribution must be invested at the same time that employee funds are invested.
• The employer could not limit the amount of an employee's investment other than to meet the limits imposed by law. The employee's investment in the plan is vested immediately; that is, the employee does not forfeit ownership of his or her own investment when employment terminates.
• An employer would not be required to make additional contributions to its PRA. Any employer contributions would be vested to the employee according to one of the following:
  • Rolling vesting: Upon termination, the employee would forfeit any employer contribution attributed to work within the last 12 months (or less, at the employer's option). However, an employee aged 55 or older who has worked for the employer for 36 months or longer would not forfeit any employer contribution at all, no matter how recent. (Note: The employer could set a zero vesting period under this method, thereby providing for immediate vesting of all employer contributions.)
  • Total vesting: Upon termination after 36 months or more from the first employee contribution to the plan (or sooner, at the employer's option), the employee would not forfeit any employer contribution at all, no matter how recent.
  If an employer changes the vesting method, all prior employer contributions would be fully vested, no matter when they were made.
• An Employment PRA for an employer with 100 or more employees would be governed by a committee of 5-9 members (the number to be determined by the employer).
  • Since a majority of the funds in an Employment PRA belong to the employees, with the unvested employer investments constituting only a small minority of the funds, a majority of the committee should be elected by the employees in a secret ballot. Employee-elected members should serve fixed, staggered terms of not less than two years. Candidates should be either current employees — but neither directors nor executives of the employer — or retirees but must currently have accounts in the plan. An employee-elected member is not automatically removed from the committee when that person terminates employment.
  • The committee would have control over selecting the trustee for the PRA, the financial institution that manages the PRA investments, and the specific investments available through that institution.
  • The committee would not have control over determining the amount of employer investment in the PRA, the vesting method or terms, the length of employment before enrolling in the PRA, or the imposition of temporary limitations on transactions (except as necessary for changing the trustee or financial institution).
  • At the employer's expense, the committee could contract with an independent accounting firm for an audit of the PRA. The accounting firm could be different from the employer's accounting firm. Otherwise, an audit of the employer must include an audit of the Employment PRA.
  • The employer would pay all expenses of the committee.

  For employers with fewer than 100 employees, the committee described above may be used. Alternatively, selecting the PRA trustee, financial institution, and investments may be done collectively by all the employees acting as a committee of the whole. For such small employers, all audits would be done as part of the audit of the employer.

• An employee could direct the investments in his or her Employment PRA within limits determined by the committee, which are constrained by the following:
  • In general, limits on PRA investments apply. However, employers with 50,000 or more employees may use special investment funds created specifically for that employer's PRA if the financial institution managing a special investment fund is regulated by the Securities and Exchange Commission.
  • Employees cannot be compelled to invest any portion of their own funds in the employer's stock or bonds. Appropriate alternative investments must be available.
  • Having no knowledge of an employee's investments outside of the Employment PRA, neither the employer nor the committee could impose any limit on the percentage of that employee's funds in any investment in the Employment PRA.
  • Any employee age 55 or older or who has participated in the Employment PRA for 60 months (whichever is earlier) may direct new employer contributions and transfer prior employer contributions to any investment available in the plan at any time. For such employees, employer contributions do not have to remain in the employer's own stock or bonds. (An employer has the option of setting a younger age or a shorter period of employment for this.)
• If the employer imposes any limitation on transactions in the PRA (e.g., a freeze in transfers from one investment to another), insider trading (as defined in the Securities and Exchange Act) and the exercising of options must be prohibited starting two weeks prior to the period of that limitation and extending through its duration. In an emergency that requires immediate limitations on PRA transactions, all profits realized on insider trading during the two-week period prior to the limitation should be paid to the PRA and all option transactions during that period should be reversed.

Transition

Of course, eliminating the confusion caused by the multiplicity of tax-sheltered retirement plans, each with its own rules, requires eliminating those plans. This cannot be done hastily without upsetting investment markets and confusing the public.

Very shortly after legislation creating PRAs is enacted, new accounts for the old plans would be prohibited. New investments in existing accounts for the old plans would be prohibited after two years. Owners of existing accounts for the old plans would have five years in which to transition to PRAs. The rules for PRAs (described above) are not only more simple than for the old plans, but also PRAs have advantages over the old plans that create incentives for this transition.

Transitions described below all assume trustee-to-trustee transfers of funds from old plans into PRAs. Transfers from PRAs into old plans would be prohibited.

"Conventional" IRAs

The new Pre-Tax PRA is very much like an IRA. However, the Pre-Tax PRA has a higher limit on annual investments, no mandatory withdrawals, and flexibility in transferring to or from an Employment PRA.

A transfer from an IRA to a Pre-Tax PRA would be tax-free and not count against the maximum annual investment in PRAs. If the same trustee and investment are used for the PRA as was used for the IRA, the law would prohibit any fee, commission, or penalty for such a transfer.

Roth IRAs

The new Post-Tax PRA is very much like a Roth IRA. However, the Post-Tax PRA has a higher limit on annual investments.

A transfer from a Roth IRA to a Post-Tax PRA would be tax-free and not count against the maximum annual investment in PRAs. If the same trustee and investment are used for the PRA as was used for the IRA, the law would prohibit any fee, commission, or penalty for such a transfer.

Keogh

While the amount of new investments for PRAs would be less than for Keogh plans, other rules for PRAs are not more restrictive. The owner of a Keogh plan would have the option of transferring it to a Pre-Tax PRA or an Employment PRA (if working for an employer that offers such a plan). If the latter is indeed available, the Keogh may also be split (in any proportion) between both kinds of PRA. This transition would be tax-free and not count against the maximum annual investment in PRAs.

401(k), 457, and other employment-based plans

Even where not similar to the new Employment PRA, transfers from those plans into Employment PRAs would be tax-free and not count against the maximum annual investment in PRAs. Employers would be able to recover not more than half the actual cost of converting to an Employment PRA in five equal annual installments, paid by the PRA. However, an employer could not charge an employee any fee for transferring any other kind of old plan into that employer's PRA, including transferring another employer's 401(k) into this employer's PRA.

The employer could delay for six months after the Employment PRA is established before allowing the exchange of the employer's stock for other investments by older or long-term employees. Then, to prevent the dumping of large amounts of stock, the employer could restrict such exchanges for each employee to not more than 10% of the number of shares transferred for that employee from the old plan per month, without any cumulative allowance for months when the employee makes a smaller or no exchange. Any such restriction would have to be removed 18 months after the PRA is established.

An employer would have three months after establishing an Employment PRA in which to create the necessary committee (at least 100 employees) or to convene a committee of the whole (less than 100 employees). However, this may also be done prior to the transition from the old plan.

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