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Investment Company Institute
Study of the Overall State of the Federal Tax System and Recommendation for Simplification
Senate Finance Committee
Pursuant to Section 8022(3)(B) of the Internal Revenue Code of 1986
May 7, 2001
The Investment Company Institute (the "Institute")1 is pleased to submit this statement to the Senate Finance Committee regarding the Joint Committee on Taxation’s study of the overall state of the Federal tax system. In the report summarizing the results of its study, the Joint Committee has recommended a number of simplifications that would affect retirement savings vehicles and other long-term savings vehicles, including education savings vehicles. The Institute strongly supports efforts by the Joint Committee to simplify the rules applicable to retirement and other long-term saving incentives, thereby increasing opportunities for Americans to save for their retirement and other long-term goals, including saving for their children’s education.
Millions of Americans use mutual funds to save for retirement and other long-term financial needs. Mutual funds are a significant investment medium for employer-sponsored retirement programs, including section 401(k) plans, 403(b) arrangements and the Savings Incentive Match Plan for Employees ("SIMPLE") used by small employers, as well as for individual savings vehicles such as the traditional and Roth IRAs. As of December 31, 1999, mutual funds held about $2.4 trillion in retirement assets, including $1.2 trillion in Individual Retirement Accounts ("IRAs") and $777 billion in 401(k)s. We estimate that about 49% of all IRA assets and 45% of all 401(k) assets are invested in mutual funds.2
The Institute has long supported efforts to enhance retirement savings and other long-term savings for Americans, including efforts that would expand savings opportunities, simplify the rules applicable to IRAs and qualified plans and enable individuals to better understand and manage their retirement assets. We support the Joint Committee’s efforts in recommending simplification of various retirement and education savings vehicles. While the Joint Committee has made numerous recommendations worthy of consideration, we focus our testimony on four basic areas: (1) IRA eligibility rules; (2) individual account plan rules; (3) required minimum distribution rules ("RMDs"); and (4) education savings vehicles.
IRA Eligibility Rules
The Joint Committee recommends eliminating phase-outs relating to IRAs and eliminating the income limits on the eligibility to make deductible IRA contributions, Roth IRA contributions and conversions of traditional IRAs to Roth IRAs. The Joint Committee also recommends that the age restrictions on eligibility to make IRA contributions should be the same for all IRAs. Further, the Joint Committee recommends eliminating the nondeductible IRA. The Joint Committee’s report states that the IRA recommendations would reduce the number of IRA options and conform the eligibility criteria for remaining IRAs, thus simplifying taxpayers’ savings decisions. We strongly support these changes. We wish to emphasize, however, that the nondeductible IRA should only be eliminated if the other recommended changes are made.
The Committee’s recommended simplification of the IRA rules responds to an urgent need. Current IRA eligibility rules are so complicated that even individuals eligible to make a deductible IRA contribution are often deterred from doing so. When Congress imposed the current income-based eligibility criteria in 1986, IRA participation declined dramatically – even among those who remained eligible for the program. At the IRA’s peak in 1986, contributions totaled approximately $38 billion and about 29% of all families with a household under age 65 had IRA accounts. Moreover, 75% of all IRA contributions were from families with annual incomes of less than $50,000.3 However, when Congress restricted the deductibility of IRA contributions in the Tax Reform Act of 1986, the level of IRA contributions fell sharply and never recovered—to $15 billion in 1987 and $8.4 billion in 1995.4 }Even among families retaining eligibility to fully deduct IRA contributions, IRA participation declined on average by 40% between 1986 and 1987, despite the fact that the change in law did not affect them.}5 The number of IRA contributors with income of less than $25,000 dropped by 30% in that one year.6
Indeed, fund group surveys show that almost fifteen years later, many individuals continue to be confused by the IRA eligibility rules. American Century Investments surveyed 753 self-described retirement savers with respect to the rules governing IRAs. The survey results found that changes in eligibility, contribution levels and tax deductibility have left a majority of retirement investors confused.7 This confusion is an important reason behind the decline in contributions to IRAs from its peak in 1986.
For these reasons, the Institute strongly supports the Joint Committee’s recommendation to repeal the IRA’s complex eligibility rules, which primarily serve to deter lower and moderate income individuals from participating in the program. A return to the "universal" IRA would result in increased savings by middle and lower-income Americans.
The Committee’s report correctly recognizes that the return of the "universal IRA" together with the availability of the Roth IRA would eliminate the need for the nondeductible IRA. However, it is important to note that, in the absence of the Committee’s other changes, the nondeductible IRA serves an important purpose—enabling those individuals not eligible for a deductible or Roth IRA to save for retirement. Consequently, the nondeductible IRA should only be eliminated if Congress repeals the income limits for traditional and Roth IRAs.
Individual Account Plan Rules
Employer-sponsored retirement plans are a key part of the system of incentives and opportunities we provide for American workers. However, as is the case with IRAs discussed above, the complexity of the rules applied to employer-sponsored plans frequently deters employers from establishing plans and workers from using them. Congress should reduce the complexity that discourages workplace retirement savings by simplifying the rules governing retirement plans.
The Joint Committee’s recommendations, in part, focus on the rules applicable to various individual account type programs. This is a good place to start, as many Americans are confused by the various plan types, each with its own set of rules. Specifically, the Joint Committee recommends conforming the contribution limits of tax-sheltered annuities to the contribution limits of comparable qualified retirement plans. The Joint Committee notes that conforming the limits would reduce the recordkeeping and computational burdens related to tax-sheltered annuities and eliminate confusing differences between tax-sheltered annuities and qualified retirement plans. The Joint Committee also recommends allowing all State and local governments to maintain 401(k) plans. This, according to the Joint Committee’s report, would eliminate distinctions between the types of plans that may be offered by different types of employers and simplify planning decisions.
The Institute supports these efforts to reduce the complexity associated with retirement plans—especially for workers trying to understand the differences between 401(k), 403(b) and 457 plans. The ability of workers to understand the differences among plan types becomes even more important as Congress considers enacting portability provisions.8 These provisions would enhance the ability of American workers to take their retirement plan assets to their new employer when they change jobs by facilitating the portability of benefits among 401(k) plans, 403(b) arrangements and 457 state and local government plans and IRAs. The Institute strongly supports portability and other efforts by Congress to simplify and conform rules that apply to different plan types in order to assist workers in understanding their retirement plans.
Required Minimum Distribution Rules
The Joint Committee suggests various significant changes to the RMD rules applicable to tax-qualified retirement plans and IRAs. Specifically, the Committee recommends that the RMD rules should be modified so that: (1) no distributions are required during the life of a participant; (2) if distributions commence during the participant’s lifetime under an annuity form of distribution, the terms of the annuity will govern distributions after the participant’s death; and (3) if distributions either do not commence during the participant’s lifetime or commence during the participant’s lifetime under a nonannuity form of distribution, the undistributed accrued benefit must be distributed to the participant’s beneficiary or beneficiaries within five years of the participant’s death. The Joint Committee states that the elimination of RMDs during the life of the participant and the establishment of a uniform rule for post-death distributions would significantly simplify compliance by plan participants and their beneficiaries, as well as plan sponsors and administrators.
While we support the Joint Committee’s efforts toward simplification of the RMD rules, we believe that the specific recommendation must be further considered to assure that there are no unintended consequences. For example, we are concerned that a rule that would require distribution of the entire account balance subject to the RMD rules within five years of the death of the participant could result in harmful consequences for the participant’s beneficiary or beneficiaries. We note that the Internal Revenue Service recently released proposed regulations that significantly simplify the rules applicable to RMDs. Under the proposed regulations, in general, a beneficiary would be permitted to take RMDs over his or her lifetime. In cases where a participant names a spouse or child as beneficiary, the ability of that beneficiary to take RMDs over his or her life expectancy would generally be preferable to a requirement that the entire account be distributed within five years of the death of the participant. Notwithstanding our concern with the specific recommendation of the Joint Committee, however, we wholeheartedly support efforts to simplify the RMD rules and would be happy to work with the Joint Committee staff to develop proposals to do so.
Education Savings Vehicles
The Joint Committee recommends several simplifications related to education savings vehicles. First, the Committee recommends eliminating the income-based eligibility phase-out ranges for the HOPE and Lifetime Learning credits. As with IRAs, we believe the phase-outs unnecessarily complicate these programs and deter participation among those eligible.
Second, the Committee recommends that a uniform definition of qualifying higher education expenses should be adopted. A uniform definition would eliminate the need to taxpayers to understand multiple definitions if they use more than one education tax incentive and reduce inadvertent taxpayer errors resulting from confusion with respect to the different definitions.
Third, the Committee supports combining the HOPE and Lifetime Learning credits into a single credit. As the Joint Committee states, combining the two credits would reduce complexity and confusion by eliminating the need to determine which credit provides the greatest benefit with respect to one individual and to determine if a taxpayer can qualify for both credits with respect to different individuals.
Finally, the Committee recommends eliminating the restrictions on the use of education tax incentives based on the use of other education tax incentives and replacing them with a limitation that the same expenses could not qualify under more than one provision. The Joint Committee states in its study that this recommendation would eliminate the complicated planning required in order to obtain full benefit of the education tax incentives and reduce "traps for the unwary."
We support the Joint Committee’s efforts to simplify the rules applicable to various education savings vehicles. Savings for their children’s education is a top priority for many working Americans. We applaud the Joint Committee’s efforts to streamline the rules relating to education tax incentives. By reducing the complexity surrounding these various tax incentives and education savings vehicles, Congress will enable more Americans to take advantage of opportunities to save for their children’s education.
Today’s individual and employer-sponsored retirement system has evolved into a complex array of burdensome requirements and restrictive limitations that can serve as barriers to retirement savings. The same holds true for education tax incentives. Simplifying the rules relating to retirement and education savings vehicles would encourage greater savings by American workers.
1The Investment Company Institute is the national association of the American investment company industry. Its membership includes 8,444 open-end investment companies ("mutual funds"), 490 closed-end investment companies and 8 sponsors of unit investment trusts. Its mutual fund members have assets of about $6.868 trillion, accounting for approximately 95% of total industry assets, and over 83.5 million individual shareholders.
2"Mutual Funds and the Retirement Market," Fundamentals, Vol. 9, No. 2 (Investment Company Institute, May 2000).
3Venti, Stephen F. "Promoting Savings for Retirement Security," Testimony prepared for the Senate Finance Subcommittee on Deficits, Debt Management and Long-Term Growth (December 7, 1994).
4Internal Revenue Service, Statistics of Income.
5Venti, supra at note 3.
6Internal Revenue Service, Statistics of Income.
7American Century Investments, as part of its "1999 IRA Test," asked 753 self-described retirement "savers" ten general questions regarding IRAs. Only 30% of the respondents correctly answered six or more of the test’s ten questions. Not a single test participant was able to answer all ten questions correctly.
8H.R. 10, the "Comprehensive Retirement Security and Pension Reform Act of 2001" and S. 742, the "Retirement Security and Savings Act of 2001."