This week on the “Heritage Explains” podcast, Adam Michel, a senior policy analyst in Heritage’s Hermann Center for the Federal Budget, explains what “universal savings accounts” are and how they work.
MICHELLE CORDERO: From The Heritage Foundation. I'm Michelle Cordero and this is Heritage Explains. The White House is expected to announce details on tax cuts for Trump's second term. One of the ideas on the table is to create tax-free investment accounts for individuals and families. Heritage has suggested a plan to President Trump that would allow families to put up to $10,000 a year into a tax-free savings fund. Yes, just in case you didn't know, while the money you keep in your savings account isn't taxable, the interest you earn on your savings is, unless it's in an individual retirement account or other tax deferred retirement account.
CORDERO: Heritage experts Steven Moore and Adam Michel recently wrote in The Wall Street Journal that the money in these universal savings accounts would ideally be invested in the stock market and the goal would be to increase household savings for Americans, helping to make them more financially stable and reduce dependence on government entitlements. But will Americans actually use these accounts more? Moore and Michel got me with this last line in their op-ed. They wrote that these accounts would allow tens of millions of Americans to tap the power of compound interest.
CORDERO: "Compound interest, he who understands it earns it. He who doesn't pays it," said Albert Einstein. While it does sound complicated, it's actually simple and billionaires like Warren Buffett claim it's the secret to their wealth. Here's one of America's most trusted voices on money, Dave Ramsey.
DAVE RAMSEY: Compound interest is what we're talking about. It's a mathematical explosion. Einstein said the compound interest is the eighth wonder of the world. Now, compound interest is simply this. You take your money down to the bank, let's take this $1,000 and we take it down to the bank and we put the money in the bank. Now, you leave it there and it earns interest and you leave the interest there. The next year you earn interest on the $1,000 and on the interest. The next year, you earn interest on the $1,00, on the interest and on the interest and you leave it there again. The next year, you earn interest on the $1,000, on the interest, on the interest, on the interest, and then you leave it there again. That's what compound interest is.
CORDERO: Simple enough, right? Now, imagine compound interest tax-free. Today, Adam Michel a senior policy analyst and Heritage's Hermann Center for the Federal Budget is going to help explain more on universal savings accounts and how if we can get Americans onboard with the idea, President Trump would be taking a major step in replacing the entitlement culture with self-made wealth. Adam, we just opened up our intro with a little bit about what a universal savings account is. How would these accounts work? How would you get a universal savings account?
ADAM MICHEL: So most Americans are familiar with a retirement savings account, your 401k through your employer, your IRA. The problem with those accounts is they have a catch. You put the money in and you have to leave it there until you're 60. Universal savings accounts are exactly like that, but without the catch. You would open them up at your bank and you'd be able to save money for whatever priorities you have in your life without the complication of all the other accounts that are out there.
CORDERO: You open them up at your bank. The same way with a 401k, could you also open them up with an employer through your salary?
MICHEL: So you could, yes, you could put a portion of your salary into the accounts. One of the things I think is complicated for many Americans is when they switch employers, often these accounts get left at employers and that scares some people away. So through a universal savings account, opening it up in your name means that you can carry it with you wherever you go. It's just one account. It's simpler. It makes it so that anyone can add money to your account, but it's still in your name and you're carrying it with you wherever you go.
CORDERO: What would you be allowed to use these savings funds for?
MICHEL: You could use it for whatever you'd like. Whether it be starting a new business or saving for buying a house or a home renovation. You could save it for college. You could save it for retirement just like we do in retirement accounts. That's the beauty of the sort of multipurpose account is a lot of people, especially in my generation, millennials tend to be scared about right now I have to pick what I'm saving for in the future. I have to pick if I'm going to save for retirement or for education or there's all these accounts have different purposes. A universal savings account says you should just be saving. We're not going to tell you what you should be saving for. You don't have to pick what you're saving for today. Just start saving. So that's the multipurpose piece of it is really the simplification.
CORDERO: Is there a time period that it would have to sit there?
MICHEL: Ideally not. I think one of the barriers for young people is that you put money in a retirement account and there's penalties if I need to take it out. Same thing for lower income folks. What if I lose my job? What if I need to help a family member with an emergency expense? These penalties that exist in the current system mean that people don't save at all because they're scared that there's restrictions put on their own money. So making these accounts so that you can spend the money whenever you want on whatever you want is really the fundamental thing that will make them so accessible to so many more people.
CORDERO: So the beauty of these tax-free universal savings accounts has to do with a line that I called out from your Wall Street Journal op-ed in our intro and that's that this would allow tens of millions of Americans to tap into the power of compound interest. In the simplest way possible, at a 101, maybe you're explaining this to me, maybe you're explaining it to our listener, maybe you're giving our listeners a way to explain it to someone that they want to teach it to, maybe their daughter, maybe their son, maybe their grandchild. What is compound interest?
MICHEL: Compound interest is the miracle of putting your money aside and letting it grow over time. You can think about this as putting your money in the stock market and letting it grow or investing in a bond that pays a little bit of money each year. It's simply the longer you let your money sit, the more it works for you and the bigger it can grow.
CORDERO: We explained in our intro that savings accounts accumulate interest and that that interest is taxed. The beauty of this is that this interest is not taxed and that's how you tap into the compound interest.
MICHEL: Correct. So current system, our current tax system, when you earn dollars from your employer, they tax it. Then if you don't want to spend that money today, but instead you want to invest it for the long haul, the government taxes you on every little gain that that money earns over time, which makes it less attractive to save. It just means that I'm more likely to spend my money today than to save it. So these accounts just remove that second layer of tax. It removes the disincentive for Americans to save, the things that tax is keeping Americans from saving as much as they otherwise would. So it allows the money that's left over that the government isn't taxing anymore to grow even faster into the future.
CORDERO: Okay. So now that we have that down, can you give me an example of how a universal savings account might work for a few different scenarios? How they could benefit someone?
MICHEL: Yeah, so take a worker who's 24 just entering the labor market and just simplicity sake, she saves $4,000 a year until she retires around 65. She could have upwards of $1 million in her universal savings account if she just lets it sit over time and the compound interest part of that is that $1 million dollars is a whole lot more than if I were to just sum up the contributions that she made each and every year.
CORDERO: About how much less would it be if taxed?
MICHEL: It would be about $250,000 if you just summed up her contributions, but instead if you allow that compound interest to take effect where it's earning a little bit each year and that little bit grows on itself time and time again, you can have significantly more money left over at the end of that savings period and that's what many Americans are left out of right now because they're scared to lock their money up forever or to just put it away for education.
CORDERO: Would there be an income level cap on these accounts?
MICHEL: Ideally we want all Americans to save more than they currently are, even wealthy Americans. That additional savings gets reinvested throughout the economy and those has other pro-growth effects. As a matter of politics, some people have floated income caps where it'd be available to people under $200,000 a year. If there are these caps, I would hope they would grow over time so that more and more Americans could have access to these accounts. But the fundamental concept is allowing more Americans access to these all-purpose savings accounts.
CORDERO: The fear of course always is that anytime there are tax cut initiatives, politics get involved and people think of course, help the wealthy, by putting these caps on it, you could help lower to middle income class families.
MICHEL: Yeah. So we know that these accounts without any cap on them have been successful in other countries and are most used by low income and young people. But putting a cap on there just makes, that just reinforces that point politically and says... It really cuts the knees off of any of the left's critique that this could somehow be just a tax cut for the wealthy. It wouldn't be, but that's where the impetus for putting any sort of restrictions comes from.
CORDERO: What other countries have tried an account like this?
MICHEL: So these accounts exist in both Canada and the UK and they are incredibly popular. People across the board use these accounts to save for all of their life's priorities. In Canada, 55% of account holders earn less than what is about $40,000 a year. So that's like your sort of typical American saver in Canada would be the one that uses these accounts the most. So we know that universal savings accounts are used by the people that we're trying to help the most, lower income savers, middle-class savers. They're also used by younger folks. Someone that's 25 in Canada is just as likely to contribute to one of these accounts as someone that's middle aged. These aren't something that's just for the rich or just for old people. This is a way to get more people across more of the distribution and more ages invested in saving for their future.
CORDERO: It's funny as I was researching this, it seemed a little bit more complicated and now that I'm talking with you about it, it actually seems like people are using them maybe in Canada or in other countries because they are more simple.
MICHEL: That's exactly right. In the United States, the system scares a lot of people off. It's complicated. It's purpose specific. If you can strip away all that complexity and say, really all we care about is that you start saving. I like to think of this as an on ramp to the existing system. It's not meant to replace health [inaudible 00:12:37] care savings accounts or retirement savings accounts. It's meant to get more people bought in to saving, just full stop. We've seen it be successful around the world as well.
CORDERO: That leads well to my next question. You wrote in the Wall Street Journal that this could be a way to reduce wealth inequality. Can you explain that a little bit more?
MICHEL: Yeah, so the current system of where the government taxes you and then spends the money on things crowds out private savings. What I mean by that is when the government is taking 15% of what you earn in payroll tax and then taking another chunk as income tax, you have less money to save yourself. So you're going to put less money away privately. So the government has supplanted that personal savings and they've replaced it with underfunded government programs all over the place, effectively making us less secure than we would be if we were saving for ourselves. So a universal savings account gets more people to start saving privately, starting to put a little bit of money away each year means that the wealth of your average American will grow and this is the opposite of the approach that we're hearing from the left.
MICHEL: The left wants to cut the top of the income distribution down by taxing them more. This is a way to lift the bottom half of wage earners up, allowing people to put more money aside so that we reduce wage inequality and wealth inequality by making lower income people wealthier rather than making a richer people poorer.
CORDERO: I'm crossing my fingers on this one. It sounds like it could be a really great thing for Americans. Thank you for helping us break it down.
MICHEL: Thanks for bringing it to the attention of your listeners. I'm really excited about this idea and I think it could help a lot of Americans plan for a more solid financial future.