Protecting 401(k) Tax Preferences
This past January, Alicia Munnell, director of Boston College’s Center for Retirement Research, and Andrew Biggs, a senior fellow at the American Enterprise Institute, stirred a hornet’s nest with a paper proposing the elimination of the tax preferences for 401(k) plans to address the funding shortfall of Social Security.
They argue that these tax benefits primarily serve higher-income earners who are more likely to have access to and participate in these plans, contributing more substantially. The authors suggest that the government redirect the significant tax revenue lost through these preferences—estimated around $185 billion annually—toward bolstering Social Security, which, as has been widely reported, will be able to pay only 83% of the benefits promised to current and future beneficiaries by 2035 absent action by Congress—leaving beneficiaries facing a disastrous 17% cut in benefits.
“If you want to talk about the issue of whether it would be a good idea to get rid of the 401(k) tax incentive and use that money toward Social Security, it would be a preposterously bad idea,” ARA CEO Brian Graff said. He explained that Social Security does a really good job of providing replacement income for low-income individuals, but doesn’t do a good job of providing replacement income for middle-income individuals. “The only way middle income individuals are going to have adequate retirement savings is actually through private savings, primarily through retirement accounts,” Graff said.
If the 401(k)’s tax incentives were eliminated, middle income people would not have enough savings. “We’d actually create more of a retirement crisis,” Graff said. “What we really need to do is to make sure Social Security is adequately funded. The way to do that is not by undermining the middle-income people.”
ICI agrees, emphasizing that the current system works: most workers build up resources from retirement plans at some point during their working careers and most retirees get income from these plans.
“The tax benefits of retirement plans are not restricted to high earners. Most tax measures (in dollars) will be skewed to high earners, simply because both income and taxes paid are highly skewed. That’s just the math,” ICI’s Holden and Brady told 401(k) Specialist. “But if you express the tax benefits of 401(k) plans as a reduction in average tax rates—even using the estimates cited by the scholars making the proposal—the benefits are a similar share of income for the top 60% of the income distribution. That’s millions of middle-class Americans receiving a material benefit from the tax-advantaged nature of 401(k)s and IRAs.”
A recent study by ICI economists analyzing tax data showed that more than 70% of retirees received income from employer plans and IRAs. And research using matched household survey and tax data by Census Bureau and Social Security Administration economists found similar results.
The data also show that—through the combination of Social Security and retirement plan income—most retirees maintain a high share of the spendable income they had prior to retirement.
“So once you account for the math, it’s clear that everyday Americans from all walks of life benefit from the tax incentives they get from saving for retirement. That’s something our Representatives in Congress should protect,” Holden and Brady said.
There seems to be a consensus among retirement industry leaders—including ARA, ICI, Empower’s Ed Murphy, among others—that Social Security does need fixing sooner rather than later.
“The lack of serious attention to Social Security is a significant problem. Anyone who wants to claim we’re in a ‘retirement crisis’ and ignores the Social Security mess is being dishonest,” Murphy said in his blueprint. “The next Congress and the Executive Branch need to prioritize this. Social Security reform, combined with the 401(k) system, together offer the best chance to help more Americans create financial security.”
Aside from eliminating the tax-preferences of 401(k)s, numerous other proposals to shore up Social Security are floating around. Some suggestions involve raising the retirement age, eliminating taxes on Social Security benefits, and increasing Social Security taxes on high earners.
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