As savings from the pandemic era dwindle and financial stress becomes the leading concern for most Americans, it is evident that the U.S. needs policies that encourage increased savings.
Personal savings provide financial security and drive economic growth through investment. However, our current tax system imposes double taxation on savings, incentivizing immediate consumption rather than long-term savings.
Understanding how the tax code impacts savings is key to exploring reforms that would better encourage Americans to save.
How Does the Tax Code Handle Savings?
The tax code addresses savings in four ways:
- Taxing both principal (the initial savings amount) and returns (interest or gains earned);
- Taxing only returns, not principal;
- Taxing principal but not returns; or
- Exempting both principal and returns from taxation.
Table 1. Four Different Tax Regimes for Saving
| Tax on Principal | No Tax on Principal | |
|---|---|---|
| Tax on Returns | Brokerage Accounts Rental Housing | Traditional IRAs and 401(k)s Defined Benefit Pensions |
| No Tax on Returns | Roth IRAs Owner-Occupied Homes | DIY Home Improvements Health Savings Accounts |
In most cases, both principal and returns are taxed. For example, if you deposit post-tax income into a savings account (your principal) and earn interest (your return), you will be taxed again on those returns.
However, there are exceptions. Some savings options allow tax benefits by either offering upfront deductions (removing tax on the principal) or not taxing the returns. For instance, contributions to Roth individual retirement accounts (IRAs) are taxed at the time of contribution but are not subject to taxes on withdrawals during retirement, including both the principal and investment earnings. Traditional IRAs, on the other hand, offer deductions now but impose taxes on withdrawals later. Certain savings vehicles, like health savings accounts (HSAs), are entirely tax-free.
The Importance of Encouraging Savings
Our current system’s double taxation on savings discourages long-term financial planning. After paying income taxes, we are taxed again on the interest earned from those savings—effectively taxing the same dollar twice.
In some instances, a single dollar of income may be taxed up to four times: initially as income tax, then as business income tax on profits from investments, followed by capital gains and dividends taxes, and finally through estate or gift taxes when passed on.
These multiple layers of taxation reduce the profitability of savings, encouraging immediate spending instead of saving for the future. This has negative consequences for financial health, investment, and economic growth.
The table below illustrates how income is taxed at a higher rate when saved rather than spent immediately, due to repeated layers of taxation.
Table 2. Comparing the Tax Burden on Immediate Versus Delayed Consumption
| Taxpayer A | Taxpayer B | |
|---|---|---|
| A. Original income | $100, immediately consumed | $100, saved and invested |
| B. Tax owed on original income (A * 20%) | $20 | $20 |
| C. After-tax income (A – B) | $80 | $80 |
| D. Invested income | $0 | $80 |
| E. Return on investment (D * 10%) | $0 | $8 |
| F. Tax owed on investment return (E * 20%) | $0 | $1.60 |
| H. Amount left to consume relative to no tax situation | $80 out of $100 | $86.40 out of $110 |
| I. Percentage Tax Burden in H | 20.0% | 21.5% |
Eliminating double taxation would create a neutral tax system for both savings and consumption, allowing individuals to decide between spending now or saving for the future without tax bias. Increased savings would lead to more investment, much of it within the U.S., bolstering incomes and improving financial security.
Under the current income tax system, only specific types of savings—primarily for retirement—receive neutral tax treatment. Even these accounts are often subject to numerous rules, regulations, and limitations.
One potential reform is the introduction of universal savings accounts (USAs), which, similar to traditional or Roth IRAs, would have fewer restrictions. Individuals could contribute up to a specified maximum each year and save for any purpose, from emergency expenses to home down payments.
Universal savings accounts represent a viable option for simplifying savings and making it more attractive to Americans.