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Emergency Funds in the Wake of the Coronavirus

Posted on Apr. 2, 2020

Emergency Funds in the Wake of the Coronavirus

Margaret Ryznar is a professor at the Indiana University McKinney School of Law.

In this article, Ryznar argues that Congress should provide a tax incentive for individuals to save for emergency funds.

The Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136) — the recently passed $2 trillion stimulus package targeting the economic effects of the COVID-19 pandemic — allows taxpayers to withdraw up to $100,000 from their retirement savings, such as section 401(k) plans, without the typical 10 percent penalty for early withdrawal. As a result, some retirement funds will be converted into rainy day funds during the pandemic, highlighting the need for individuals to have proper emergency funds in the future.

By many indications, at least one more stimulus package will be needed once the public health crisis abates.1 That future tax legislation, in the wake of COVID-19, should expand its focus from retirement saving to emergency fund saving. Under current law, tax incentives for saving are limited to retirement saving in the form of IRAs and section 401(k) plans.2

However, retirement accounts do not make for ideal emergency funds. Almost half of all working-age families have no retirement account savings, and as of 2013, the median for families with retirement savings was approximately $60,000.3 Many people have difficulty saving for a retirement that is decades away and are intimidated by the significant sums needed for retirement.4 Further, congressional action, such as through the CARES Act, is needed for them to access these savings early without penalty. Finally, early withdrawals from retirement accounts jeopardize retirement funds, which benefit from long periods of investment. The investments in retirement accounts are also likely in stocks, given their long-term nature, which have lower values in an economic crisis. Selling those assets undermines the eventual returns from the retirement accounts, which are an important supplement to Social Security funds.5

Yet the COVID-19 pandemic illustrates the need for people to have easy access to emergency funds. Many taxpayers worry that their stimulus checks will not be nearly enough.6 Some have delayed coronavirus-related healthcare because they fear the resulting bill.7 Others have to endanger their health by continuing to work during the pandemic to pay bills.8 These examples highlight that saving in general, not just retirement saving, needs tax incentives.

Governments can either encourage saving or require it for their citizens. Like many countries, the United States has chosen to encourage saving, often through the tax law. Whether through financial incentives or penalties, tax drives people’s behavior. For decades the United States has been providing incentives for retirement saving.9 By the late 1970s, IRAs and 401(k) plans were available to Americans.10 Section 403(b) retirement accounts, which are functionally similar to 401(k) plans, also came into the tax code for the benefit of employees of some tax-exempt organizations.11 Now is the time to shift the focus to emergency funds.

There are some foreign models for using tax law to encourage people to save for emergency funds. For example, the United Kingdom offers individual savings accounts (ISAs).12 Payments into these accounts are made from after-tax income. The accounts are exempt from income tax and from capital gains tax on the investment returns, and no tax is due on money withdrawn from ISAs at any time.

Meanwhile, Canada began the tax-free savings account program in 2009.13 These accounts function similarly to the ISAs: Although there is no tax deduction for contributions, withdrawals are tax free. The annual contribution limit is $6,000, which increases with inflation over time. However, people can indefinitely carry forward their unused contribution amounts until they hit the cumulative maximum, and they can recontribute the amounts they withdrew in the previous year up to the cumulative maximum. Any Canadian resident age 18 or older with a Social Insurance number can open a tax-free savings account.

These foreign models have advantages that may spur saving, which is the goal of U.S. policy as well. Even the health savings account created in the United States in 2003 is a useful model for a tax-advantaged emergency fund.14 These accounts receive tax advantages and allow Americans to save for a specific purpose — healthcare costs.

Aspects of the IRA and Roth IRA may also be instructive in developing a new savings account.15 In particular, the IRA and Roth IRA need not be offered by an employer, which is an important characteristic for an emergency savings account. This is especially true as many people become gig workers. For moderate- and low-income workers, the previous “My Retirement Account” or “MyRA” program offered a starter account for those who lacked access to an employer-provided retirement plan.16 Funds were invested in safe Treasury securities. Once the balance in this starter account reached $15,000 or the account had been open for 30 years, the balance was transferred to a private Roth IRA.

The expense to the federal government of providing new tax incentives for emergency funds is offset by tempering the economic damage resulting from the lack of savings. Further, to make these true emergency funds, tax legislation could limit annual contributions to a smaller amount, such as $2,000 for each taxpayer. Finally, although a new emergency savings account would contribute to the patchwork structure of the U.S. tax savings framework, it would address people’s concerns about locking up money for decades. This is especially useful for lower-income households when emergency expenses arise.

There is speculation that the COVID-19 pandemic will change this generation of Americans. This presents an opportunity for Congress to help nudge them toward saving more.

FOOTNOTES

1 Mike Lillis, “Pelosi: Democrats Eyeing More Cash Payments in Next Emergency Bill,” The Hill, Mar. 25, 2020.

2 Cynthia Blum, “Migrants With Retirement Plans: The Challenge of Harmonizing Tax Rules,” 17 Fla. Tax Rev. 1 (2015).

3 Monique Morrissey, “The State of American Retirement: How 401(k)s Have Failed Most American Workers,” Economic Policy Institute (Mar. 3, 2016).

4 This is especially true given that Social Security funds are set to be depleted by 2034. See Ryan Bubb, Patrick Corrigan, and Patrick L. Warren, “A Behavioral Contract Theory Perspective on Retirement Savings,” 47 Conn. L. Rev. 1317 (2015).

5 See Social Security and Medicare Boards of Trustees, “A Summary of the 2019 Annual Reports” (Apr. 2019).

7 Sean D. Hamill, “Woman Who Died of COVID-19 Refused to Go to Hospital, Worried About Bills, Her Son Says,” Pittsburgh Post-Gazette, Mar. 25, 2020.

8 Charisse Jones and Josh Peter, “Despite Coronavirus, Millions of Workers Can’t Stay Home. Are They Safe?USA Today, Mar. 25, 2020.

9 Ausher M.B. Kofsky, “Rehabilitating Frankenstein’s Monster: Repairing the Public Policy of the Roth IRA,” 80 Alb. L. Rev. 161, 182 (2017).

10 John K. Eason, “Retirement Security Through Asset Protection: The Evolution of Wealth, Privilege, and Policy,” 61 Wash. & Lee L. Rev. 159, 190 n.114 (2004).

11 David A. Pratt, “Very Serious Business: Sense and Nonsense Under Section 403(b) of the Internal Revenue Code of 1986,” 59 Alb. L. Rev. 1197, 1200, 1204 (1996).

12 For more detailed information, see gov.uk, “Individual Savings Accounts (ISAs).”

13 For more detailed information, see Government of Canada, “The Tax-Free Savings Account” (Nov. 24, 2016).

14 Treasury, “Health Savings Accounts (HSAs)” (Dec. 1, 2015).

15 IRS, “Roth IRAs” (Jan. 10, 2020).

16 Richard L. Kaplan and Kate S. Poorbaugh, “What’s the Matter With Retirement Savers?” 47 Conn. L. Rev. 1281, 1296 (2015).

END FOOTNOTES

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