Tax Changes to Retirement Savings Could Have Big Impact

By Stephen Miller, CEBS Sep 15, 2011

Workers with the lowest incomes would be among the biggest losers under various proposals to reduce tax limits for savings in 401(k)-type plans, according to testimony presented to the Senate Finance Committee by the nonprofit Employee Benefit Research Institute (EBRI), among others.

At a Sept. 15, 2011, committee hearing, EBRI Research Director Jack VanDerhei presented new modeling results of who would likely be affected—and by how much—if the existing level of allowable tax-deferred savings in private-sector defined contribution retirement plans were changed, as some advocates have proposed.

“As expected, highest-income workers generally would be the most affected if federal tax limits in 401(k)-type plans were lowered,” VanDerhei said. “But the surprising result we found is that the lowest-income workers would also be very negatively affected, and many report that they would reduce contributions or stop saving in their work-based retirement plan entirely if the current exclusion of worker contributions for retirement savings plans were ended.”

For instance, VanDerhei said, if the current exclusion of worker contributions for retirement savings plans were ended in 2012 and replaced with flat-rate tax credits as proposed recently by Brookings Institution Fellow William Gale, the average reduction in 401(k) accounts at normal Social Security retirement age would range from 11.2 percent for workers currently ages 26-35 in the highest-income groups to 24.2 percent for workers in that age range in the lowest-income group.

An EBRI analysis of the bipartisan deficit commission’s proposal to reduce 401(k) savings caps to $20,000 a year or 20 percent of income (the so-called “20/20 cap”) starting in 2012 would most affect the highest-income workers—not surprising, because those with high income tend to save the most in these kinds of retirement plans. However, EBRI found that the cap would cause a big reduction in retirement savings by the lowest-income workers as well. EBRI’s modeling is based on its proprietary Retirement Income Security Projection Model.

Tax Change Proposals

Currently, the combination of worker and employer contributions in a 401(k) plan is capped by the federal tax code at the lesser of $49,000 per year or 100 percent of a worker’s compensation. As part of the effort to lower the federal deficit and reduce “tax expenditures” (as tax advantages are termed), two major proposals have surfaced:

  • The Brookings Institution proposal by William Gale, which would replace existing 401(k) tax deductions with a flat-rate refundable credit that serves as a matching contribution in a retirement savings account, using an 18 percent credit or a 30 percent credit.
  • The “20/20 cap” included by the National Commission on Fiscal Responsibility and Reform in its December 2010 report, The Moment of Truth.

VanDerhei noted that Gale’s analysis assumes that workers will keep their aggregate retirement contributions constant and that employers will not make changes in their employer match in 401(k) plans. Under any cost-benefit analysis, VanDerhei said, it is very difficult to determine how workers not currently covered and/or participating in a defined contribution plan will react to the incentives under the Gale plan.

“Given that the financial fate of future generations of retirees appears to be so strongly tied to whether they are eligible to participate in employer-sponsored retirement plans, the logic of modifying (either completely or marginally) the incentive structure of workers and/or employers to save in a defined contribution plan needs to be thoroughly examined,” VanDerhei said.

Other Testimony

Among employer and industry representatives testifying at the hearing, James A. Klein, president of the American Benefits Council, submitted a statement for the record from his group and the American Council of Life Insurers advising that "The employer-sponsored retirement system helps millions of American workers at all income levels accumulate retirement savings. As Congress considers broad-based tax reform, we urge lawmakers to ‘do no harm’ and avoid actions that would discourage participation in employer plans.”

Klein defended "the critical tax incentives that make employer-sponsored plans so effective—both as a driver of economic growth as well as a source of personal financial security." He added, “Some have suggested fundamental changes to the tax treatment of 401(k)s and other defined contribution plans. Such proposals are deeply flawed and should be rejected.”

Judy A. Miller, director of retirement policy for the American Society of Pension Professionals & Actuaries, testified that "Americans save at work because it works. We are very concerned that the proposals under discussion—slashing the contribution limits, or turning the current year’s exclusion into a credit—would discourage small business owners from setting up or maintaining a workplace retirement plan. This is the exact opposite of what needs to be done."

However Karen Friedman, executive vice president and policy director for the union-aligned Pension Rights Center, called on Congress to re-examine the tax incentives associated with 401(k) and other retirement savings plans, "so that those tax breaks work more efficiently and equitably." She testified, "These tax incentives are meant to encourage employers to set up plans and to encourage employees to save for retirement. However, they end up disproportionately benefitting the most affluent employees, who do not need tax incentives to save."

Many Face Retirement Risk

Recent EBRI research shows that the adoption of automatic enrollment and auto escalation of contributions in 401(k) plans has reduced the likelihood of Baby Boomers and Generation X being at risk of inadequate retirement income to cover basic expenses and uninsured health care costs in retirement. However, even with these improvements, almost half of Baby Boomers and Generation X are still at risk, and 70 percent of households in the lowest one-third when ranked by pre-retirement income were classified as at risk.

In aggregate, EBRI estimates, retirement savings shortfalls (determined as a present value of retirement deficits at age 65) for Baby Boomers and Generation X (expressed in 2010 dollars) are $4.55 trillion, for an overall average of $47,732 per individual still assumed to be alive at age 65.

Stephen Miller, CEBS, is an online editor/manager for SHRM.


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