New retirement savings idea would upend traditional 401(k) plans

March 7, 2021

As the new administration starts to promote its policies, several social issues may come to the fore in proposed tax legislation.

The low personal savings rates have been a concern for many years. Retirement savings is part of such concerns. Recent focus on wealth and savings inequalities represents another concern. Then there is the perpetual concern about “fair” tax treatment for all taxpayers.

A pending tax law proposal may wrap all these into a discussion about tax benefits for retirement tools, whether IRAs or 401(k)s. The simple explanation is that instead of pretax contributions that provide bigger tax benefits to the rich, everyone would get a flat tax credit.

Workers currently may contribute pretax dollars, which reduces their annual taxable income and provides a tax deferral, but doing so causes regular tax on the entire amount when funds are eventually withdrawn in retirement.

The upfront tax break is larger and more valuable for those in higher tax brackets. For example, a single filer earning $60,000 would be in the 22% bracket and receive a $220 tax break per $1,000 contribution, while someone in the top 37% bracket would have a savings of $370. Those numbers are for federal tax only. Add California tax and the amounts are about $260 versus $470.

Another point is that upper-income earners tend to save more in 401(k) plans. The more they contribute, the larger the tax savings. The pending tax proposal would instead “equalize” the incentive system by ending such deductions and replacing them with flat tax credits for each dollar saved. A final benefit percent is not yet certain but many estimates are about 26% because it would be revenue-neutral for the federal budget.

The result of the new plan would give the same tax benefit, an identical $260 tax credit per $1,000 retirement contribution, for someone earning $600,000 as well as someone making $60,000.

By some estimates, almost $3 trillion in tax benefits will be distributed to those saving for retirement over the next 10 years, but those tax breaks are spread “incredibly unequally” with low-income earners getting very little.

That is the concern.

A counterargument from the Tax Policy Center estimated that the revenue-neutral number should be 30%. But the tax benefits would be enjoyed overwhelmingly by the bottom 90% of households based on income, with tax increases falling disproportionately on the top 10% of earners.

Do you consider that an issue?

How do we as a society motivate everyone to save? Savings is generally considered a good idea. Please note that the more money you have in retirement, the less dependent you are on Social Security alone.

The real issue and interesting question is how savings behavior would change. Changing a system in place for decades may not alter behavior quickly. Convincing more people to save more money and enhance their financial security has not led to great results so far. Lowering the amount eligible for retirement savings and the resulting tax benefit may cause many employers to decide that the costs outweigh the benefits and then close the pension plans. Not a desirable result.

Progressives have long complained that deductibility is an “upside-down” incentive that favors the rich, while tax credits, as long as they are fully refundable, are far more accessible to all.

The general conclusion that a tax credit would make the system more progressive, bringing gains to middle- and low-income earners and losses to the wealthy, is likely to be politically attractive. Getting it done may be difficult.

Many industry organizations intend to oppose the proposed changes. Besides having concerns for their own businesses, the main argument is that such a change does not necessarily mean that lower-income earners would actually save more. Higher earners also might save less in traditional retirement plans.

Would the wealthy save roughly the same amounts with or without the tax break? Roth IRAs might become more attractive to upper-income households. In any case, the retirement savings landscape would change significantly. The return of traditional defined-benefit pension plans with their current tax-favored status is unlikely. Such plans are simply too complicated and expensive, as recent years have shown.

In any case, let me encourage everyone to save, especially for retirement.

Mark Sievers, president of Epsilon Financial Group, is a certified financial planner with a master’s in business administration from the University of California, Berkeley. Contact him by email at [email protected].