The Inefficiencies of Existing Retirement Savings Incentives

An elderly employee poses for a photo at her workplace in Lincoln, Nebraska, August 2012.

Endnotes and citations are available in the PDF and Scribd versions.

This issue brief contains a correction.

America’s middle class faces a growing retirement crisis. More than half of all working-age households are expected to be at risk of having to cut back their standard of living—often making painful adjustments—when they retire. There are several reasons for the ever-larger looming crisis, but people’s inability to save enough money is a key obstacle to achieving more retirement security. On average, Americans need to save between 10 percent and 20 percent of their salaries each year outside of Social Security to ensure a secure retirement. Yet nearly one-third of working-age Americans have no retirement savings or pension, and less than half of all private-sector workers participated in a retirement plan at work in 2013, the last year for which data are available.

The growing retirement crisis results, in part, from inefficient savings incentives embedded in the U.S. tax code. Households that need the most help saving for retirement receive the least assistance from the multitude of savings incentives. The federal government and several state governments use the tax code to encourage people to save. These savings incentives typically come in the form of tax advantages and vary by type of savings, such as individual retirement accounts, or IRAs; 401(k) plans; or Roth IRAs.

These tax incentives, however, fall short of allowing workers to secure adequate retirement savings. First, existing savings incentives can be overwhelming and incredibly complex. People need to understand which savings plans are available; how much they and their employer can contribute to the various plans; how long to keep their money in tax-advantaged savings; and how their decisions interact with current and future tax rates for personal income and capital income.

Second, savings incentives often benefit higher-income earners more than middle- and lower-income earners. Higher-income earners face higher tax rates and thus enjoy greater tax breaks from existing savings incentives; they can better take advantage of maximum contributions to multiple retirement plans because they have more income. Higher-income earners are more likely than lower-income earners to have a retirement plan through their employer—which come with more savings incentives than other retirement plans. Higher-income earners also earn a higher net of tax rate of return and  pay lower fees, so even if a high- and low-income earner save exactly the same amount of money, the higher earner will accumulate more retirement assets. All of these factors end up boosting savings the most for higher-income earners, who arguably need the least assistance to save for retirement.

Third, even as the savings incentives fail to prepare households adequately for retirement, the public loses out on increasingly large amounts of tax revenue that otherwise would have been collected without these tax breaks. Federal and state governments forgo a substantial amount of tax revenue to create incentives meant to help people save for retirement but in reality produce little additional savings. The federal government alone annually forgoes more than $100 billion in personal income tax revenue due to retirement savings incentives. And state governments with income taxes further lose out on substantial tax revenue—about $20 billion, according to one estimate from researchers at The New School—as they generally offer the same tax breaks on state income taxes as the federal government.

To be clear, savings incentives are not a bad idea. In the United States, however, the existing tax structure has failed to adequately prepare most people for retirement. This issue brief will illustrate the link between the retirement crisis and savings incentives and further examine several key elements within this relationship:

  • Existing retirement savings incentives are inefficient, as they are unnecessarily complex and skewed in favor of higher-income earners.
  • These savings incentives exacerbate inequities in a system that heavily relies on employer-based retirement benefits such as 401(k) plans, as access to employer-based plans is unevenly distributed and as such plans offer greater tax advantages than nonemployer plans such as IRAs.
  • Lower-income earners receive less of a benefit from existing savings incentives than higher-income earners.
  • With little help available from retirement savings incentives, a growing share of households is inadequately prepared for retirement.
  • Inadequate retirement savings are unevenly distributed. The retirement savings shortfall is especially pronounced among lower-income households, communities of color, and single women.

This issue brief highlights the need for policymakers to address the reality of the growing retirement crisis. Amid inaction, a growing number of Americans will spend their golden years in poverty. More retirees will struggle to pay their bills, rely more and more on help from relatives and friends, and simultaneously increase demand on public safety net programs. Tax reform could play an integral part in addressing the looming shortfall in retirement savings, largely by simplifying savings incentives and better targeting incentives to those who truly need help preparing for retirement.

The full issue brief continues in the PDF.

* Correction, August 9, 2016: This issue brief has been updated to reflect that in the sentence indicated in the PDF, the authors looked specifically at the retirement incentives included in the referenced data.

Christian E. Weller is a Senior Fellow at the Center for American Progress and a professor of public policy at the McCormack Graduate School of Policy and Global Studies at the University of Massachusetts, Boston. Teresa Ghilarducci is the Bernard L. and Irene Schwartz chair in economic policy analysis in the Department of Economics and the director of the Schwartz Center for Economic Policy Analysis at The New School in New York.