Tax benefits of retirement savings in jeopardy
Published in MarketWatch
By Pinar Cebi Wilber
WASHINGTON (MarketWatch) — In an effort to slow and reverse our spiraling national deficit and debt, lawmakers will likely put all tax expenditures (tax code spending via exemptions, deductions, or credits to select groups or specific activities) under close scrutiny.
Among those on the chopping block are tax-qualified retirement plans, and this could spell trouble when you consider the severe savings problem in the U.S.
Tax reform is a popular Washington buzzword. Despite much skepticism among the media and political pundits that President Obama and Congress can agree on anything, there have been recent developments which suggest that tax reform may, in fact, be more than a buzz.
The coveted legislative bill number HR 1 has been assigned to tax reform, 11 separate congressional tax working groups are busy holding hearings, and the rare cooperative spirit between the House and Senate tax writing committees suggest that tax reform may indeed be gaining traction — and for good reason.
The just-released fiscal year 2014 budget is the most recent attempt to limit the size of these plans by prohibiting individuals from accumulating over $3 million in IRAs and other tax-preferred retirement accounts. The $3 million figure is tied to an amount sufficient to finance an annuity of not more than $205,000 per year in retirement, which is also the current maximum benefit permitted to be paid under a qualified defined benefit plan in 2013 and is adjustable for increases in cost of living. It looks like this is another attempt to increase the taxes paid by the so called “1 percenters” but the impact might be wider.
As noted by Jack VanDerhei of the Employee Benefit Research Institute, when interest rates start rising in the future, “you’re likely to have individuals where a significant number of them could end up triggering that limit.”
For example, the National Commission on Fiscal Responsibility and Reform plan, released in 2010, would limit tax-deferred contributions to retirement accounts to the lesser of $20,000 a year or 20% of income.
This “20-20 cap” would also include the employer contribution. To illustrate, consider a regular Joe with an income of $75,000 and an employer contribution of $4,000. Under the current system, he is allowed to save up to $17,500 in his 401(k) plus the employer match, on a pretax basis. Under the 20-20 plan, this person can only save $11,000 after his employer match. The remaining $6,500 would be included in taxable income, thereby increasing his April 15 tax bill.
Will the regular Joe would save that money for retirement if the tax incentive is taken away?
In fact, EBRI’s 2011 Retirement Confidence Survey tackled this very question. When asked about the importance of the deductibility of their retirement savings plan contributions in encouraging them to save for retirement, almost 62% of respondents answered “very important.” In fact, 76% of respondents with incomes between $15,000 and $25,000 classified tax deductibility of contributions as “very important,” the largest percentage of respondents for any income class.
Similarly, when asked, “Suppose you were no longer allowed to deduct retirement savings plan contributions from your taxable income. What do you think you (and your spouse) would be most likely to do?” One in four workers indicated that they would either completely eliminate or would reduce their contributions to retirement savings plans.
Again, the lowest-income category ($15,000 to $25,000) had the largest negative reaction to this proposal, with 56.7% indicating a reduction in retirement saving. These results demonstrate the importance of tax-deferred retirement plans among low-income households.
Limitation on existing tax incentives might also discourage some businesses from sponsoring and maintaining plans. Given the significant legal responsibilities and costs associated with running a retirement plan, loss of tax benefits, especially for key employees, could disincentivize the plan sponsorships, hurting every member of that plan. And given that only 5% of workers save for retirement on their own without the benefit of an employer sponsored plan, this could put additional pressure on an already fragile retirement system.
Then there are the macro consequences of such limits. Creating additional barriers to retirement saving will have a negative impact on our already sluggish economic growth. The U.S. is still struggling to make up the ground lost during the Great Recession. Economic indicators show that U.S. gross private domestic investment is still below pre-recession levels.
Coupled with tax and regulatory policies that are not very business friendly, decreasing savings will put in danger the much needed productivity enhancing investments that help make the U.S. economy globally competitive.
Much has changed since the first employer sponsored pension plan was introduced in 1875 by American Express Co., but it is widely agreed upon that Americans are still not saving enough for their retirement years. Given demographic changes, increasing medical and long-term care cost and questions regarding the sustainability of the Social Security safety net, personal savings has taken on an increased importance.
Congress shouldn’t further jeopardize retirement security for millions of Americans by creating additional disincentives for saving through changes in the tax code.
Dr. Pınar Çebi Wilber is a senior economist for the American Council for Capital Formation, a nonprofit, nonpartisan organization promoting pro-capital formation policies and cost-effective regulatory policies.