Wednesday, May 20, 2009

Disclosing the rules clearly: Congress should lead by example!

President Obama has spoken derisively of the multi-page, fine-print statements familiar to millions of credit card-users. Last week, he told a receptive crowd in New Mexico that “you should not have to worry that when you sign up for a credit card, you’re signing away all your rights. You shouldn’t need a magnifying glass or a law degree to read the fine print that sometimes doesn’t even appear to be written in English.”
NYT 5/20/2009

Congress has recently focused a spotlight on two industries that make it hard for consumers to make good financial decisions: credit card issuers and 401(k) providers.

I agree that both industries need to do a better job of disclosing their fees and rules clearly and transparently to their customers. Hidden fees and obscure "gotcha!" technicality clauses should not be buried in pages of boilerplate fine print. People shouldn't need a magnifying glass, an attorney, a CPA, and a Talmudic scholar to compare confusing credit card offers and hidden mutual fund fee structures in order to choose intelligently among the options.

However, Congress should also lead by example and clean up its own act. Our income tax code is a well-documented mess of frequently obscure, confusing, and arcane technicalities. According to National Taxpayer Advocate Nina Olson, there are over 3.7 million words in the income tax code. A plethora of confusing different hidden gotcha! clauses lurk among those 3.7 million words.

Taxpayers can't make truly well-informed financial decisions unless Congress writes clearer and more straightforward tax laws.

Here's one simple hypothetical example--a composite case study based on situations that commonly occur to low-income clients at VITA sites like ours):

Sarah is a single mother of two kids, earning $7 per hour working full-time, $14,000 per year. She is also attending college part-time, trying to finish up her degree so she can make a better life for her family down the road. In the meanwhile, to save on housing and child care costs, she and her kids are still living with her parents.

Sarah wants to save up enough money to move into a modest home of her own in a few years, once she finishes college and gets a better job with a different employer. Her current employer offers her a traditional 401(k) plan, but due to economic difficulties, there's no employer match for her contributions. Still, she's read all the news stories about the "tax advantages" of saving in a 401(k) plan, and after carefully perusing IRS Pub 575, she confirms that the tax rules allow penalty-free withdrawals from a 401(k) plan if used for the purchase of a home. So she goes down to HR and signs up to contribute $1,000 to the 401(k) plan this year.

Next year, when she goes to her tax preparer at the VITA site, she's feeling pretty pleased with herself. It wasn't easy scrimping and saving to stay on a budget and still manage to save that $1,000 in her 401(k), but she did it! She hands over her tax documents to her preparer, who interviews her, crunches the numbers in the software, and has the return quality reviewed by another VITA volunteer before sitting down with Sarah to explain her tax return.

Sarah wants to know: "How much did my $1,000 401(k) contribution increase my tax refund this year?"

"Gulp,"--her preparer swallows hard before delivering the bad news. "Well, actually, saving that money inside a 401(k) didn't increase your refund, it DECREASED your refund, because it decreased your "earned income," which decreased your Earned Income Credit." The bottom line is that your federal refund is about $150 less than it would would have been if you'd just put the money into a regular savings account.

"Not only that, but when you take the money out in a few years to buy a house, you'll probably be in a higher tax bracket than you are now, because you probably won't be ready to buy a house until you have a better-paying job than the one you have now. Although it's true you won't have to pay a "penalty" for taking the money out, you will have to pay ordinary income tax on it at that higher bracket rate."


So much for transparency!

Congress is fond of patting itself on the back and promoting all the special tax breaks for working, saving, first-time homebuying, etc., but they don't make it easy to figure out the "bottom line."

Wealthy taxpayers can hire high-priced advisors to "run the numbers" for them and project different possible tax scenarios, as well as helping them find the lowest cost investment options, credit cards, etc. Sarah doesn't have the money for high-priced financial and tax advice.

And the scenario above just covers ONE of the many possible tax GOTCHAs that Sarah could fall into unwittingly, thanks to Congress's confusing "spaghetti code" tax law. As National Taxpayer Advocate Nina Olson pointed out in her most recent report to Congress, there are at least 16 different tax incentive programs to save for retirement, 11 different incentive programs for higher education, etc., etc., etc. (To take just one example, if Sarah had put the money in a Roth IRA or 401(k) plan rather than a traditional 401(k) plan, it would have been a much better deal for her particular situation. Her Roth contribution would not have reduced her current year earned income credit and when she's ready to buy a house, she would be able to take her contributions out later without paying income tax on it.)

As a single parent raising two kids while working fulltime and going to school part-time, Sarah doesn't have a lot of time to waste on reading "Gotcha" clauses to figure out the best financial options--whether they are in credit card offers, mutual fund prospectuses, or the tax laws created by Congress.

And there are more traps for the unwary among other categories of vulnerable taxpayers: for example, retired senior citizens trying to figure out how best to manage their retirement savings to last.

Congress, it is great that you are working on laws to require credit card companies and 401(k) providers to give their customers clear information so they can make well-informed decisions.

But, Congress, it's also time to lead by example and CLEAN UP YOUR OWN ACT! You've been given lots of good advice on tax simplification--from the National Taxpayer Advocate and from the last bipartisan presidential advisory panel on tax reform. More advice will be coming your way in early December from President Obama's task force on tax code overhaul--I hope you will listen.

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