Encouraging Retirement Savings in the Tax Code

In 2014, the Bipartisan Policy Center (BPC) launched the Commission on Retirement Security and Personal Savings, led by former Senator Kent Conrad and WL Ross & Co. Vice Chairman Jim Lockhart. The commission will consider and make recommendations regarding Social Security, pensions, defined contribution savings vehicles, strategies to generate lifetime income and other factors that affect retirement security.

This BPC-staff authored post is the 14th in a series that outlines the state of savings and retirement in America and provides a sense of the challenges that the commission seeks to address in its forthcoming report.

Billions of dollars in tax revenue are foregone each year to incentivize Americans to save for retirement. Federal income tax expenditures for retirement are expected to exceed $800 billion between 2014 and 2018, though questions surround the methodology of these projections (i.e., the provisions may not be as expensive as advertised).^{1, 2} About half of these tax expenditures go towards defined contribution (DC) plans (such as 401(k)s)—which are estimated to cost around $399 billion between 2014 and 2018. The bulk of the rest go towards defined benefit (DB) plans ($248.3 billion), traditional individual retirement arrangements (IRAs) ($69.5 billion), Keogh plans for partners and sole proprietors ($52.1 billion), Roth IRAs ($30.2 billion), and the Saver’s Credit, a tax credit for low-income workers ($6 billion).

Wealthy and middle-class Americans disproportionately benefit from the current system. Low-income workers are less likely to have access to employer plans, do not have the means to take full advantage of contribution limits, and are in lower tax brackets, which means that tax-deferred savings and pensions are less valuable to them than they would be for those who pay a higher marginal income tax rate.³ Rather, their income tax benefits for retirement savings are largely limited to the Saver’s Credit, which comprises a very small fraction of the total system of retirement tax expenditures.

Current System of Income Tax Expenditures for Retirement Savings

The Saver’s Credit—also known as the Retirement Savings Contribution Credit—is a tax credit designed to incentivize retirement savings among low- and middle-income households. It was borne out of a bipartisan deal in 2001 between then-Representatives (now Senators) Rob Portman (R-OH) and Ben Cardin (D-MD), ultimately included as part of that year’s Economic Growth and Tax Relief Reconciliation Act, which also increased contribution limits for DC retirement plans and IRAs.

A person’s credit is equal to a percentage of their retirement plan contributions up to $2,000 for a given year (or $4,000 for joint filers). The size of the credit is determined by the adjusted gross income (AGI) level of the filer. Single filers with AGI of no more than $18,250 can receive a credit equal to 50 percent of plan contributions. For those with AGI between $18,251 and $19,750, the credit decreases to 20 percent of contributions. Single filers with AGI between $19,751 and $30,500 receive a credit equal to 10 percent of contributions. No credit is available for single filers with AGI above $30,500, and the credit is non-refundable, meaning that filers must have a federal tax liability to receive the benefit. However, many lower-income individuals do not.⁴

Tax deferral occurs when taxpayers are able to delay a portion of their income-tax liability. Traditional IRAs and 401(k)s are examples of tax-deferred retirement accounts, as contributions to and earnings within them are not subject to income tax. Rather, income taxes apply at the time of withdrawal, which can be advantageous to retirement investors. Retirees tend to have lower incomes than working-age adults, meaning that withdrawals from these accounts are often taxed at lower rates than the original deferred earnings would have been. Tax deferral is also the primary tax benefit for DB retirement plans; the contributions and earnings are not subject to income tax, and income tax is applied to pension income during retirement.⁵ The benefits of tax deferral are larger for higher-income workers, who generally have a larger differential between the earnings in their working years and their incomes in retirement.

Roth-Style Accounts can be established in the form of Roth IRAs or Roth 401(k) plans. They differ from tax-deferred accounts in that contributions are made with after-tax dollars, and any withdrawals after age 59½ (or the plan retirement age, if higher) are not subject to income tax. Consequently, investment earnings are never taxed, except in the case of an early withdrawal.

Both Roth and tax-deferred IRAs and 401(k) plans are subject to contribution limits, which are adjusted annually for changes in consumer prices. The annual contribution limit⁶ for IRAs currently stands at $5,500 (or $6,500 for those age 50 and older).⁷ 401(k) plan participants are typically subject to two limits: an employee contribution limit of $18,000 (or $24,000 for those age 50 and older) and a total contribution limit (employee plus employer) of $53,000 (or $59,000 for those age 50 and older).⁸

Proposed Legislative Reforms

Policymakers have proposed a number of reforms to make the tax expenditures more progressive.

Limiting Tax-Advantaged Accounts: The President’s Fiscal Year 2016 Budget Proposal calls for placing overall limits on contributions to tax-advantaged retirement accounts. The proposal would prohibit individuals from making new contributions once their tax-advantaged assets are sufficient to purchase an annuity that provides an annual income of $210,000 in retirement—around $3.4 million at age 62. The administration’s rationale is that the current system disproportionately benefits the wealthy—who can afford to make larger contributions—as well as those who have access to stock options with high growth potential. Critics claim that the structure of this proposal would entail significant red tape, as individual contribution limits would vary each year based on factors such as age, interest rates and assumptions regarding future rates of return. According to the Government Accountability Office, around 9,000 taxpayers have at least $5 million in their IRAs.

Reforming the Saver’s Credit: This has been the focus of a number of proposals and is an area of reform that could be politically viable, due to the provision’s bipartisan support.

• Make the Saver’s Credit Refundable: One criticism of the Saver’s Credit is that it does too little to incentivize retirement savings among low-income workers, as individuals only receive the benefit if they have a federal income tax liability. According to the Tax Policy Center, filers in the bottom two income quintiles generally owe nothing in federal income taxes, meaning that they realize no benefit from the Saver’s Credit. In 2013, Congressman Richard Neal (D-MA) proposed the Retirement Plan Simplification and Enhancement Act. This legislation includes a proposal to make the Saver’s Credit refundable. This would allow individuals with no federal tax burden to receive the benefit in their tax refund, and would thus strengthen savings incentives for low-income Americans.
• Simplify Filing Requirements: Another criticism of the Saver’s Credit involves low public awareness, due in part to the complexity of filing requirements. The credit is not available for individuals who file via the 1040EZ, the fastest and easiest way to file taxes. Rather, individuals are required to fill out a separate form—the 8880—as well as the standard 1040 form. In 2014, Senators Susan Collins (R-ME) and Bill Nelson (D-FL) introduced the Retirement Security Act of 2014, which included a proposal to allow filers to claim the Saver’s Credit on the 1040EZ.

Although tax expenditures are without doubt a useful way to incentivize retirement savings, the magnitude and costs of the current provisions deserve close analysis. Today’s system also does little to encourage savings among low-income individuals. BPC’s Commission on Retirement Security and Personal Savings is working to address these important issues in the context of its comprehensive policy recommendations, with a final report expected in early 2016.

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¹ As we noted in an earlier post, a longer-term analysis of the cost of retirement tax preferences would likely yield lower estimates.

² JCT estimates include foregone income taxes only. Employer contributions to DB and DC retirement plans are excluded from the payroll taxes that finance Social Security and Medicare, which is a significant additional tax benefit.

³ Some lower earners, especially those with children, do not even have any federal income tax liability (or have negative liability, because their refunds exceed taxes withheld) thanks to the earned-income and child tax credits. For these individuals, tax deferral might have the effect of deferring income to a point at which their tax bracket would actually be higher. Roth accounts would still offer some tax advantage to these individuals.

⁴ All thresholds are doubled for joint filers.

⁵ Tax-deferred accounts also allow for employer contributions, which are tax deductible.

⁷ These are combined limits for both Roth and tax-deferred IRAs and 401(k)s.

⁷ Higher-income holders of both employer plans and traditional IRAs are subject to an additional deferral limit: namely, single filers with an AGI over $71,000 are not entitled to a deferred tax benefit on a traditional IRA..

⁸ These limits are for standard IRAs and fully qualified plans. Different limits apply for SIMPLE IRAs and SIMPLE 401(k) plans.