Tax Breaks for Retirement Savings Do Not Help the Workers Who Need Them Most

As the Center for American Progress¹ and others have written, the tax breaks intended to boost retirement savings impose a high cost on the federal budget, disproportionately benefit upper-income households, and do little to assist those who are most at risk of poverty when they retire.

These incentives fail to accomplish their goal primarily because most of their benefits go to high-income households, who would save even without incentives and have the lowest risk of financial insecurity in their retirement years. In 2019, 60 percent² of the benefit of the income tax breaks for retirement savings accounts went to the highest-income 20 percent of households, and only 1.5 percent of the benefit went to the lowest-income 20 percent. Moreover, while Social Security provides a critical foundation—constituting the majority of the income received by most older Americans—research³ shows that financial security during retirement depends on having multiple sources of income.

The Securing a Strong Retirement Act of 2022,⁴ also known as the SECURE Act 2.0, expands and modifies tax incentives aimed at boosting retirement savings. The proposed law, which recently passed the U.S House of Representatives, puts forward some important changes—including expanding automatic enrollment in retirement savings plans and strengthening protections for part-time workers—but it does not address the fundamental flaws in the current incentives that make them of little use to low- and middle-income families. Congress should prioritize policies that target assistance to those who need it most.

This report examines the failures of existing retirement savings incentives and the limitations of the SECURE Act 2.0. It then offers policy recommendations that would advance the goal of broad-based retirement security for those who would gain little from this legislation.

The ability to exclude contributions to pensions and tax-preferenced retirement accounts—also known as defined contribution accounts—from income and payroll taxes is the second-largest federal tax expenditure,⁵ costing $276 billion in lost federal revenues in 2019.⁶

Current tax preferences for retirement savings come in two main forms. The first reduces a person’s taxable income by the amount they or their employer contributes to retirement savings accounts such as 401(k) plans and traditional individual retirement accounts (IRAs).⁷ The money inƒX these accounts—both contributions and the investment earnings on those contributions—is not taxed until it is withdrawn. In the second type of account, commonly known as a Roth IRA, contributions are made with income that is taxed at the time it is earned, and withdrawals of both contributions and investment earnings are tax-free. Complex rules govern the size of allowable contributions to tax-preferenced retirement accounts and the conditions under which withdrawals can be made prior to age 59½. A third, much smaller incentive—the saver’s credit—is available to a more limited range of taxpayers. This credit is discussed in detail below.

Higher-income households are much more likely to take advantage of tax breaks for retirement savings, as shown in Figure 1. In 2019, 77 percent of households in the top quintile of the income distribution received a benefit, compared with just 19 percent of those in the bottom quintile and just less than half of those in the middle quintile.⁸ And in 2018, the most recent year for which data are available, just 41.7 percent⁹ of wage earners contributed to a defined contribution account.

Figure 1

Not only do a larger share of high-income households have retirement accounts, but the average balance in those accounts also far exceeds that of accounts held by lower-income savers. According to the Federal Reserve’s most recent Survey of Consumer Finances, families in the top 10 percent of the income distribution held accounts with an average value of $692,800, while those in the bottom half of the distribution had accounts with an average value of $57,400.¹⁰ (see Figure 2) Moreover, while the cost to the federal budget of savings incentives more than doubled between 2004 and 2020, retirement insecurity has increased.¹¹ The share of households considered at risk of not having sufficient income during retirement, as measured by the National Retirement Risk Index, rose from 41 percent in 2004 to 49 percent in 2019.¹²

Figure 2

Policies to boost retirement security should focus on the people whose limited earnings make it difficult for them to save for retirement and who are most at risk of financial instability in old age. The current system of incentives, however, provides large tax breaks to high-income households relative to middle-income households and little or no assistance to low-income families. This upside-down structure results from structural features that favor high-income households. These include:

• In 2020, incentives enabled tax-sheltered savings of up to $57,000 per year—$63,500 for those older than 50—in an employer-sponsored retirement plan.¹³ This is more than the income of the typical full-time worker who earned $56,287 in the same year, but benefits higher-income families, who have more discretionary income available to save.¹⁴
• The largest incentives are structured as deductions or exclusions that are worth more to savers in higher tax brackets—in other words, people with the highest incomes. A $1 deduction results in 37 cents in tax savings for a family in the top tax bracket, but just 10 cents in savings for a family in the lowest tax bracket.¹⁵ People whose incomes are so low that they owe no tax, before refundable credits such as the earned income tax credit (EITC) are taken into account, receive no tax benefits from contributing to a retirement savings plan.
• The complexity of existing incentives coupled with stiff penalties for early withdrawals can discourage participation among low-income households who may not have other resources to draw on in the event of an emergency.¹⁶
• The saver’s credit, the one retirement tax incentive ostensibly aimed at helping lower-income households, is not refundable and thus provides no benefit or at most a very limited one to lower-income households who owe little or no tax to offset with the credit.¹⁷

Despite their high and rising cost, existing retirement savings incentives have done little to address the problem of retirement insecurity. Research shows that current incentives largely result in higher-income households shifting savings from nontax privileged accounts to tax-advantaged accounts and do little to encourage greater savings overall.¹⁸ As a result, the federal budget foregoes substantial tax revenue each year in order to provide significant benefits to households who likely would have saved without an incentive while failing to improve the retirement security of those most in need of assistance In recent decades, lawmakers have magnified the fundamental flaws of the current retirement savings incentives by increasing the maximum amount that can be contributed to an account and delaying the age when minimum distributions must begin, along with other changes that largely benefit higher-income households.¹⁹

Current incentives widen the racial wealth gap

The upside-down structure of existing incentives, coupled with disparities in retirement savings patterns, exacerbate the racial wealth gap. Workers of color are disproportionately concentrated in jobs and sectors of the economy with weak workplace retirement plan coverage.²⁰ This, combined with other factors such as low levels of intergenerational wealth transfers, makes it difficult for families of color to save for retirement.

A recent survey found that nearly two-thirds of Hispanic families and nearly half of Black families lacked a retirement savings plan in 2019.²¹ In contrast, roughly one-fourth of white families and fewer than one-tenth of high-income families had no retirement savings accounts. Because white Americans are more likely to have retirement accounts and, when they do, to have larger balances, they disproportionately benefit from current incentives. The same survey found that white families with individual retirement savings accounts—such as IRAs and 401(k) plans—had average balances nearly triple those of Black and Hispanic families.²² (see Figure 3)

Figure 3

Several features of the SECURE Act 2.0 would over time help expand access to employment-linked retirement savings plans. Changes such as requiring employers to automatically enroll workers in 401(k) plans and allowing employers to consider employees’ student loan payments for purposes of matching contributions would likely increase participation, particularly among workers with relatively low takeup rates.²³ Similarly, requiring employers to expand part-time worker coverage would help many employees gain access to workplace-linked 401(k) accounts.

However, these changes do not address the fundamental flaws in the current system and other provisions would further skew the benefit structure toward the wealthy. It is important to note that many workers do not currently save because they need every dollar they earn to make ends meet. For these individuals, diverting earnings to restricted savings accounts can unduly lower a family’s standard of living and make it difficult for them to take on expenses that could ultimately lead to higher earnings or a higher standard of living prior to retirement.²⁴

The SECURE Act 2.0 raises the age for required minimum distributions, encouraging tax sheltering

The costliest provision in the SECURE Act 2.0 is a delay in the age when retirees must take minimum distributions from traditional IRAs and 401(k)s.²⁵ Under the SECURE Act 2.0, that age would increase over the next decade from the current age of 72 to age 75. Minimum distribution requirements are designed to ensure that savings incentives fulfill their purpose of encouraging people to save for retirement while also ensuring that savings that went untaxed earlier in life are ultimately taxed. Raising the age for required distributions does nothing for lower-income retirees who depend on their savings to make ends meet while benefiting the wealthy by allowing them to shelter more income for a longer period of time, avoid paying taxes while they are alive, and ultimately to pass more untaxed assets on to their heirs. The use of retirement accounts as a tax shelter is illustrated by the fact that among 65- to 70-year-old owners of both traditional and Roth IRAs—there is no required distribution for Roth accounts, since deposits into those accounts come from after-tax income—99.6 percent made a withdrawal from their traditional account in 2016, while just 17 percent made a withdrawal from a Roth.²⁶

The larger catch-up limits in the SECURE Act 2.0 reward higher-income savers

Another costly provision of the SECURE Act 2.0 would allow individuals approaching retirement age to make additional catch-up contributions to their retirement savings accounts. Under current law, individuals ages 50 and older can contribute an additional $6,500 per year ($3,000 to SIMPLE IRA plans) above the otherwise applicable limit. The SECURE Act 2.0 would allow individuals ages 62, 63, and 64 to contribute an additional $10,000 ($5,000 for SIMPLE IRA plans) and would index that amount for inflation.²⁷ A Vanguard Investors survey found that in 2020, just 15 percent of account holders made a catch-up contribution of any size when given the option, a figure that has been consistent over time.²⁸ Yet of this 15 percent, nearly 6 in 10 account holders with incomes of $150,000 or more made catch-up contributions, while fewer than 1 in 10 individuals with incomes less than $100,000 did so. Vanguard also found that 58 percent of those affected by the current contribution limit have incomes of $150,000 or more, and most of these savers already had larger account balances.

The SECURE Act 2.0’s expanded Roth IRA preferences favor the wealthy and increase long-term costs

The SECURE Act 2.0 offsets most of the cost of expanding retirement tax breaks with changes designed to encourage savers to favor Roth accounts over traditional IRAs.²⁹ For budget-scoring purposes, these changes result in increased revenues in the near term, since savers pay taxes on the amounts they contribute to a Roth account, forgoing the immediate deduction available for traditional IRAs or 401(k)s. However, the long-term budget impact is to increase costs, since distributions from a Roth account are not taxed upon withdrawal.³⁰ Moreover, since there are no minimum distribution requirements, wealthy account owners can use Roth accounts to pass untaxed savings on to their heirs.

Privileging Roth IRAs over traditional accounts also worsens existing inequities since these accounts are most beneficial to individuals who are likely to stay in the same tax bracket when they retire—higher-income households with more assets—compared with those who anticipate a lower post-retirement tax bracket—lower-income households with fewer assets. As explained by researchers at the Tax Policy Center:

[A]t a constant 33 percent tax rate, a Roth [IRA] shelters 50 percent more income from tax than the same dollar contribution to a traditional retirement account. That means, assuming the same pattern of contributions and withdrawals, the Roth IRA contribution costs 50 percent more in present value terms than the traditional contribution.³¹

Previous CAP research offers recommendations for substantially reforming the retirement savings system through efforts such as a universal thrift savings plan³² and overhauling the structure of tax-based incentives.³³ Other more modest approaches outlined below would make important incremental progress for those who receive little or no benefit from the current savings incentives.

Make the saver’s credit refundable

A more equitable approach to reform would restructure the saver’s credit, which is the one retirement savings incentive designed to assist lower-income households. The current saver’s credit provides a modest credit to households with incomes of up to $66,000 for married tax filers who contribute to a retirement savings plan. However, because of the credit’s design, very few potentially eligible taxpayers claim it, and when they do, few receive the full amount. Researchers found that from 2006 through 2014, only 3.25 percent to 5.33 percent of eligible filers claimed credits averaging $156 to $174.³⁴

One of the main reasons why so few households claim the credit is that it is nonrefundable. The lack of refundability prevents households whose potential credit is greater than their federal income tax liability from receiving some or all of the credit’s benefit. While the House-passed SECURE Act 2.0 would increase the size of the credit for many middle-income families starting in 2027, it would not make the credit refundable, which means that low-income savers would still be shut out.

Making the saver’s credit refundable and structuring it as a match for amounts individuals contribute to an account would enable more of its intended audience to begin to build meaningful retirement savings. This approach, included in measures authored by Sen. Ron Wyden (D-OR)³⁵ and Rep. Judy Chu (D-CA),³⁶ would help the households most at risk of having inadequate retirement savings and begin to reduce the racial and other inequities embedded in the current system of tax preferences. Another reform that would boost the impact of the saver’s credit would be to simplify the process for claiming it by allowing households to use the “short form” (1040EZ) to file tax returns claiming the credit, similar to the process used for the EITC.

Lift asset limits in anti-poverty programs such as Supplemental Security Income

Many low-income individuals also face obstacles to saving in the form of asset limits imposed by safety net programs. The Supplemental Security Income (SSI) program, which provides a very modest income floor for the poorest seniors and people with disabilities, has an extremely strict limit on allowable savings. People are ineligible for SSI if their assets—with a few exclusions, such as a home, one vehicle, and household goods—exceed $2,000.³⁷ This limit, which has not been increased in more than 30 years, prevents individuals from saving even modest amounts to prepare for unforeseen expenses, much less the significant amounts needed for retirement security.³⁸ On May 3, 2022, Sen. Sherrod Brown (D-OH) and Sen. Rob Portman (R-OH) introduced bipartisan legislation, the Savings Penalty Elimination Act, to lift the SSI asset limit to $10,000, or $20,000 for married couples, and index it to inflation.³⁹ This proposal should be included in any legislation aimed at helping Americans save.

Rein in mega IRAs

In stark contrast to the modest retirement savings of the majority of Americans, a small number of high-wealth households have exploited loopholes in the current system to accumulate massive balances in tax-favored retirement savings accounts.⁴⁰ In 2019, just less than 500 taxpayers held accounts of more than $25 million, with an average balance of $154 million. These so-called mega IRAs have skyrocketed in number over the past decade: Between 2011 and 2019, the total number of accounts with balances of $5 million or more nearly tripled from 9,057⁴¹ to 28,615.⁴² Wealthy investors can use these accounts to avoid paying capital gains taxes⁴³ on appreciated assets and as a strategy to dodge estate taxes otherwise due on accounts passed on to heirs.⁴⁴

Policymakers could limit the abuse of high-balance IRAs through reasonable reforms, including several that were included in various drafts of the fiscal year 2022 budget reconciliation bill:

• Limit allowable investments to publicly traded securities, thus preventing well-connected investors from using IRAs to shelter gains on purchases of pre-initial public offering stock.
• Ban backdoor mega IRAs that result from the transfer of employer-sponsored accounts funded by after-tax contributions to Roth IRAs, which have no minimum distribution requirements.
• Establishing maximum balance limits on defined contribution plans held by high-income individuals.

These recommendations would limit the ability of the highest-income households to use provisions designed to promote a secure retirement to build vast, untaxed wealth.

The current tax breaks for retirement savings are costly and skewed in favor of high-income households. The SECURE Act 2.0 does not do enough to address these shortcomings. Reforms to this deeply flawed system should prioritize equity and the low- and middle-income families most at risk of having insufficient savings in their retirement years.

The author would like to thank Jessica Vela for her valuable contributions to this report.