Will Congress slash your 401(k) tax break?
The deductions on IRAs and 401(k) contributions is one of the deficit reduction options known in Washington as “tax expenditures” — that is, revenue the government foregoes through deductions, exclusions or exemptions. Overall tax expenditures — which also include deductions for big-ticket items such as mortgage interest and employer health plans – are worth more than $1 trillion a year.
The retirement saving deductions for pensions and defined contribution plans cost $143 billion in 2010, according to the federal Office of Management and Budget; some argue that the cost really is lower, since the deductions are deferrals of taxes that are paid down the road in retirement.
President Obama’s National Commission on Fiscal Responsibility and Reform recommended capping combined employee/employer pre-tax contributions to 401(k)s at $20,000 or 20 percent of income, whichever is lower. That would be a substantial cut in deductibility, since the employee deduction alone currently is capped at $16,500 (savers over age 50 can make additional $5,500 “catch-up” contributions).
The commission also recommended expanding the saver’s credit, which helps lower-income savers by allowing a credit of $1,000 for individual filers ($2,000 on joint returns) on a percentage of qualified contributions.
Meanwhile, the House Subcommittee on Health, Employment, Labor and Pensions heard testimony earlier this week on limiting the retirement deduction.
This might be Washington’s second most important retirement policy regulatory issue — coming right after the Department of Labor’s preparations to add fiduciary responsibility to workplace retirement plan platform providers. Yet the odds look long for any immediate action on retirement savings deductibility. “Is it likely to be a big part of anything prior to the 2012 election? Probably not,” says Dallas Salisbury, president of the Employee Benefit Research Institute (EBRI).
Still, the retirement industry is taking the matter seriously. The American Benefits Council offered testimony at the House hearing, and the American Society of Pension Professionals and Actuaries recently issued a study disputing how much deductibility actually costs the U.S. Treasury.
Opponents of the retirement savings deduction argue that it fails to serve a broad public good, because the deduction is used only by high-income taxpayers who actually take deductions. “Every tax expenditure should be examined annually for effectiveness, efficiency and equity,” says Teresa Ghilarducci, director of the Schwartz Center for Economic Policy Analysis at The New School for Social Research and author of When I’m Sixty-Four: The Plot Against Pensions and the Plan to Save Them (Princeton University Press).
Ghilarducci argues that retirement saving wouldn’t decline if the deduction disappeared. “There’s no evidence that it increases saving; much of the academic literature shows that higher income people are simply moving investments they would have made anyway [in taxable accounts] to a tax-preferred account. And there are 25 million taxpayers in the bottom two quartiles who don’t take deductions, so they’re getting no subsidy at all from the federal government on their contributions.”
Salisbury concedes the point on deductibility, but argues that low income savers still benefit because the tax incentive encourages employers to provide benefit plans in the first place — often including matching contributions and automation features. “What you end up with is that the tax preference for high-income workers causes plans to be sponsored that otherwise wouldn’t be sponsored, and that auto-enrollment features are really boosting participation rates at the low-income end of the spectrum.”
EBRI’s annual Retirement Confidence Survey this year included a first-time question on the importance of tax deductibility in encouraging retirement saving. The results were counter-intuitive: the lowest-income workers were most likely to describe the deduction as “very important,” even though these workers aren’t taking deductions on their tax returns. “Most people in those income ranges haven’t taken the time to figure out what the after-tax effect would be – they just know they are losing something,” says Jack VanDerhei, EBRI’s research director. “From a financial economic perspective, it’s entirely counter-intuitive.”
And an EBRI analysis to be published this summer shows that the deficit commission’s proposal would have the greatest impact on high- and low-income savers. High income savers would be clipped by the dollar cap on deductible contributions, while lower income workers would be hit by the 20 percent-of-income limitation.
Ghilarducci doesn’t advocate ending the retirement tax expenditure. Instead, she’d put it toward a new government-sponsored Guaranteed Retirement Account, which would feature mandatory contributions and serve as an add-on to Social Security, 401(k)s and IRAs. That’s her wish list; she’d also buy into replacing the deduction with a more progressive standard tax credit that would be available to all workers .
“Anyone who saves in a 401(k) would get the same amount, regardless of income. For people making over $90,000 a year, it would be a cut in the government subsidy they get now, but it would be more beneficial to lower income workers.”