The Point of Tax Deferred Savings

One of the proposals that President Obama will reportedly make in his State of the Union Address is to remove the tax exemption for earnings in 529 college savings accounts.

Right now, the way that a 529 savings account works is that someone (parent, grandparent, etc.) puts money into the 529 savings account for the beneficiary (future college student.) The money that is put in is after-tax money. You don't get to deduct the money you contribute from your income taxes, though some states do allow you to deduct contributions to that state's plan from state income tax. Over time, the savings grow. When the kid goes to college and takes the money out to pay for tuition, books, board, etc., the student does not have to pay taxes on the money earned.

Obama's proposal is that the savings would only be tax deferred, not tax free. Thus, when the student took the money out to pay for college, the student would pay taxes on the capital gains of the money in the account.

So, for sample:

If I put $2k in a savings account for DarwinJr, and fourteen years later that $2k has grown to $10k, which he takes out to help pay for college, currently he would pay no taxes on that $10k, but under Obama's proposal, he would pay taxes on the $8k in investment earnings when he took the money out.

Apparently critics on the left object to 529s and also to retirement savings accounts such as 401ks and IRAs because they figure that the "rich" do more saving than the poor, and so they'd like to tax all possible earnings instead in order to help the poor more, and figure the rich should be able to figure out how to save on their own without any tax benefits.

I have a principled preference that we tax people less, so I'm not much in sympathy with this line of thinking. But I also think there's an interesting behavioral aspect to tax deferred savings accounts such as 529s and 401ks.

See, a couple of the big problems with savings are:

- It's easy to put off doing it: not making the contribution this month.
- If some sort of financial squeeze comes along, the obvious thing to do seems to be to tap the savings and figure you'll make it up later.

Tax exempt savings accounts help with these because many people place an inordinate (indeed, arguably irrational) value on tax exemptions, and they are also inordinately hesitant to incur tax "penalties".

So, with a tax exempt account such as an IRA, where you can write off a certain size contribution to the account each year from your taxes, people place an inordinate emphasis on making sure that they get their contribution in every year.

People are also more inclined to set up to make direct payroll contributions to tax exempt accounts, because that way they "get away" with paying lower taxes. Indeed, payroll often provides a handy calculator which assures you that you'll practically see no less in your take home if you put just a little more into your 401k every check.

So the tax exemption encourages people to be more regular in making their contributions.

Additionally, these same tax exempt accounts tend to come with a hefty penalty that you pay for taking the money out early, and using it for something other than what the account is designed for. (For instance, raiding your 401k to pay for a new furnace, or taking money out of your kids 529 to pay for car repairs.)

These mean that people are much, much less likely to tap these savings early to deal with financial emergencies. This might seem frustrating when the emergency is going on. I know there have been times when we've run into some sort of financial crunch when seeing a 401k statement was maddening. There's $30k that I own and I can't even touch it to deal with this problem! But by forcing people to find other ways to make up those shorter term emergencies, the regulations actually perform a useful service. The biggest thing on your side in longs term savings projects such as saving for retirement is time. Taking money out sets you back a long term, not just because you lose the earnings you would have had on that principle while it was in there, but also because people are generally faster to pay off debts than to build up savings. This isn't super surprising. If you miss putting money in your savings account, you just have a little less saved. If you fail to pay on a loan, they come after you.

So, for instance, I'm dead sure that when we have the Great Boiler Disaster and had to put nearly 10k on our credit cards to get the heat back, we paid that 10k off much faster than we would have re-filled 10k that we'd taken out of savings. Thus, it's probably a good thing that we couldn't raid my 401k, even though at the time it was hugely frustrating to see how much money I "had" in there, but couldn't touch.

All of these, I suspect, roll together to mean that we actually get a pretty good deal, as a polity, by providing modest tax incentives for saving for major life expenses such as college and retirement. Encouraging people to put money into savings, and then making it very hard to get that money out early, means that people will be better provided for for those needs, and less likely to need to fall back on borrowing or state assistance.