Individual retirement accounts (IRAs) were established by the U.S. government to encourage saving. An individual who deposits part of current earnings in an IRA does not have to pay income taxes on the earnings deposited, nor are any income taxes charged on the interest earned by the funds in the IRA. However, when the funds are withdrawn from the IRA, the full amount withdrawn is treated as income and is taxed at the individual's current income tax rate. In contrast, an individual depositing in a non-IRA account has to pay income taxes on the funds deposited and on interest earned in each year but does not have to pay taxes on withdrawals from the account. Another feature of IRAs that is different from a standard savings account is that funds deposited in an IRA cannot be withdrawn prior to retirement, except upon payment of a substantial penalty. (L03)
a. Greg, who is five years from retirement, receives a $10,000 bonus at work. He is trying to decide whether to save this extra income in an IRA or in a regular savings account. Both accounts earn 5 percent nominal interest, and Greg is in the 30 percent tax bracket in every year (including his retirement year). Compare the amounts that Greg will have in five years under each of the two saving strategies, net of all taxes. Is the IRA a good deal for Greg?
b. Would you expect the availability of IRAs to increase the amount that households save? Discuss in light of (1) the response of saving to changes in the real interest rate and (2) psychological theories of saving.