This is part of a new CAP series called the “Tax Expenditure of the Week.” The series aims to explain the often-confusing constellation of tax breaks in a way the average taxpayer can understand. Every Wednesday we will focus on one tax expenditure, explaining what it is, what purpose it is intended to serve, and whether it is effective toward that purpose. We will also review relevant reform proposals.
Subjecting these dozens of tax breaks to greater scrutiny is part of our broader focus on making government work better and achieving better results for the American people, which is the goal of CAP’s “Doing What Works” project.
Tax-deferred retirement savings are the second-largest tax expenditure in the United States. They are expected to cost the federal government about $142 billion in foregone tax revenue this year and about $788.3 billion over the next five years. We’ll examine how well they promote retirement security and whether any reforms could make them more effective.
What are the tax breaks for retirement savings and why are they tax expenditures?
The tax code encourages people to save for retirement by allowing them to shelter from taxes personal income invested in 401(k) plans, individual retirement accounts, employer pension plans, and other similar savings vehicles.
The purpose of these incentives is to encourage people to save for retirement and not rely solely on Social Security. Every dollar you set aside for the future reduces your tax bill this year. They represent substantial tax breaks because they allow individuals to defer taxes on their earnings and investments, and ultimately to pay taxes at lower rates since people tend to be in lower tax brackets when they retire.
In total, these programs are expected to cost the government about $142 billion in foregone tax revenue this year, making tax-deferred retirement savings the country’s second largest “tax expenditure.”
How does it work?
Three decades ago, the most common tax-favored retirement plans were so-called defined benefit plans, or pensions paid to retirees based on a set formula—typically based on their years of service to an employer and pay level before retirement.
Starting in the 1980s, “defined contribution” plans began to predominate. The most popular was established in 1978 by Internal Revenue Code section 401(k) (hence, the term “401(k) plan”). In defined contribution plans, workers direct some of their income to investment accounts, sometimes supplemented by employer contributions. These accounts become available to the workers at retirement. The amount in them is not known in advance. Rather, it’s determined by how much workers have socked away over the years and how well the investment portfolio has performed. Another popular defined contribution plan is the Individual Retirement Account, or IRA, which is a savings vehicle established by individuals rather than by employers.
Within certain limits, money put in these types of savings accounts is not subject to income tax. Consider a simplified example: If you earned $100,000 last year, but put $5,000 in a 401(k) plan, the federal government taxed you as if you only earned $95,000. And the tax benefit doesn’t end there. Not only is the money set aside for retirement not taxed, but the investment gains are also not considered income for tax purposes. You’re only taxed when you take the money out in retirement, when you’re more likely to be in a lower tax bracket. So if in retirement, you withdraw $10,000 a year from a 401(k), you do pay income taxes on that $10,000.
A “Roth” IRA or 401(k) is a newer type of account where the saver pays taxes on her pre-retirement contributions, but gets to watch them grow tax deferred—and doesn’t pay income tax on them when she takes the money out in retirement.
Are tax breaks on retirement savings effective?
An effective policy to promote retirement security would focus on those workers who struggle the most to save part of their paychecks, and who face the greatest uncertainty in retirement. Our current system does the opposite.
Existing retirement incentives steer the overwhelming majority of the tax benefits toward high-income earners. The statistics are striking. According to the Tax Policy Center, 80 percent of the tax benefits are claimed by the top 20 percent of income earners. The bottom three-fifths of Americans enjoy only 7 percent of the benefit.
Much of the reason for the skewed benefit is that the more money you make, the more likely you are to have a 401(k) plan with generous employer contributions. Nearly half of Americans do not have access to a retirement plan at work, with participation rates disproportionately lower among African-American workers and in particular Latino workers. 
High-income individuals also have more disposable income to save. The greater a person’s income, the more likely he is to contribute to a 401(k) or IRA. Though there are limits on the amount of tax-deductible and overall contributions individuals can make to tax-favored savings vehicles, those limits are high. The combined annual limit on employee and employer contributions to a 401(k) plan is $49,000 in 2011.
The tax system steers retirement subsidies toward high-income individuals in another way. Workers in higher tax brackets receive more savings than workers in low tax brackets because the tax incentives are structured as deductions. Last week’s installment of this series illustrated that a similar “upside-down” effect occurs with the tax break for employer-sponsored health insurance. The unequal distribution of tax breaks will be a common theme as this series counts down the nation’s largest.
Bottom line: The tax expenditure for retirement savings allows people with the means to put away large amounts of money to do so tax deferred. It is unclear how much the expenditure boosts savings, since many high-income workers would put away a portion of their income even in the absence of any tax incentive. Indeed, personal savings rates have declined significantly in the United States over the past 50 years, while retirement insecurity has increased.
Critics therefore have questioned whether our tax-deferred retirement savings incentives encourage new saving or simply permit wealthy individuals to shift their money into tax-deferred accounts.
How can we make the retirement tax incentives more effective?
The retirement tax incentives can be restructured so that they encourage savings in a more progressive way, with more broadly shared benefits. One way to do that is to provide tax credits for retirement savings instead of deductions. Tax credits provide dollar-for-dollar reductions in the amount of taxes a person owes regardless of the tax bracket they fall in. So a middle-income person who owes $5,000 in income tax a year and a wealthy person who owes $50,000 would both benefit equally from a $1,000 tax credit. The middle-income person would see his tax bill go down to $4,000, and the wealthy person’s down to $49,000. There is a so-called “saver’s” tax credit, but it is modest and could be designed better to reach more people.
National Economic Council Chairman and former CAP Senior Fellow Gene Sperling has proposed a progressive framework for retirement security. One of his ideas is to create a universal 401(k) plan, available to all workers, and replace the current tax deductibility component with a flat tax credit of 30 percent for all worker savings. That plan would distribute the retirement-savings incentives more fairly and target the people most likely to reach retirement without enough money to live on.
Recently, the Bipartisan Policy Center proposed a similar reform: a 12 percent “refundable” tax credit for retirement savings available also to those who do not owe federal income taxes at the end of the year.
Together, the retirement savings incentives embedded in the tax code represent one of the government’s largest social programs. They should be evaluated based on how well they encourage and enable savings, especially among the low-income and middle-class Americans who struggle the most to save for retirement.
Seth Hanlon is Director of Fiscal Reform for CAP’s Doing What Works project. We hope you’ll find this series useful, and we encourage your feedback. Please write to Sethdirectly with any questions, comments, or suggestions.
Next week: A closer look at the third-largest tax expenditure: the mortgage interest deduction.
Thanks to James Hairston for his contributions to this week’s installment.
. C. Copeland. (2010). Employment-Based Retirement Plan Participation: Geographic Differences and Trends, 2009. (Washington, DC; EBRI Issue Brief No. 348). See figure 23. http://www.ebri.org/pdf/briefspdf/EBRI_IB_10-2010_No348_Participation.pdf
. Corporation for Enterprise Development & Annie E. Casey Foundation, Upside Down: The $400 Billion Asset-Building Budget (2010), p. 11. http://www.cfed.org/assets/pdfs/UpsideDown_final.pdf
. See, e.g., Teresa Ghilarducci & Daniela Arias, The High Cost of Nudge Economics and the Efficiency of Mandatory Retirement Accounts (Schwartz Center for Economic Policy Analysis, November 2009).
. See President’s Economic Recovery Advisory Board, The Report on Tax Reform Options: Simplification, Compliance, and Corporate Taxation (2010), pp. 30-31. http://www.whitehouse.gov/sites/default/files/microsites/PERAB_Tax_Reform_Report.pdf