The retirement system in the United States is working. It sounds like a howler, but it happens to be true, and 401(k)s are playing a big role, according to a new paper from the Investment Company Institute.
Author Peter Brady, who has a forthcoming book, Who Benefits from the U.S. Retirement System, finds a combination of tax deferral and the Social Security is progressive. That is, as a percentage of their lifetime earnings, lower earners receive more in lifetime benefits from the combination of Social Security and tax deferral than higher earners receive.
“Consistent with previous research, this study shows that the benefits of tax deferral are proportionately higher for higher-earning workers,” Brady writes. “Tax deferral, however, is only one part of the U.S. retirement system. Social Security is the primary component of the U.S. retirement system, and the benefits of the Social Security system are proportionately higher for workers with lower lifetime earnings.”
Policy discussions of tax deferral often focus on the reduction in taxes enjoyed by workers and ignore the higher taxes these workers will pay during retirement, he adds. Contributions to retirement plans are tax-deferred, not tax-free. For the higher-paid workers analyzed in the study, tax deferral affects when taxes are paid more than it affects the total amount of taxes paid over a lifetime. For these workers, increased taxes during retirement offset, in present value, more than half of the reduction in taxes enjoyed while working.
Contrary to conventional wisdom, he notes, the marginal benefits of tax deferral (the benefits of deferring an additional $1 of compensation) are higher, on average, for the lower-earning workers analyzed in this study than they are for the higher-earning workers. Although the lower earners face lower marginal tax rates while working, their marginal benefits are higher because they experience the largest drop in marginal tax rates during retirement, Brady says.
“The benefits of tax deferral increase with lifetime earnings because of the design of the Social Security system, not because of the design of the income tax. In this study’s simulations, higher earners benefit more from tax deferral—not because they benefit more on every dollar they contribute to a retirement plan, but because they contribute more dollars. Because Social Security benefit payments replace a smaller share of their pre-retirement income, higher earners need to save more to ensure they meet the target replacement rate in retirement.”
Brady uses the findings to warn policymakers of monkeying with the current system—specifically because current proposals only target defined contribution plans.
“The most prominent reform proposals for retirement plans would make the tax code less fair,” he argues. “The current income tax is roughly neutral in its treatment of the different forms of tax deferral—tax deferral through defined benefit plans and defined contribution plans; tax deferral for employer contributions and employee contributions; and tax deferral by private-sector workers and government employees. Proposals to further limit or fundamentally change tax deferral would violate this neutrality by targeting only DC plans, or by targeting only tax-deferred contributions made by workers to DC plans and individual retirement accounts (IRAs).”
In fact, proposals to limit the up-front benefits of tax deferral would make the tax code more complex, Brady concludes. Tax deferral is fairly simple for workers to understand and for the government to administer, he notes.
“It allows a portion of a worker’s compensation to be set aside for retirement and requires only that the compensation be included in taxable income when it is distributed to the worker. Many proposals to replace tax deferral would make the decision to contribute to a retirement plan more complex and would require the government to track information on individual taxpayers over an extended period of time.”