Committee for a Responsible Federal Budget

TPC Examines Options to Change Retirement Savings Incentives

Jul 1, 2014 | Taxes

The Tax Policy Center and Urban Institute have issued a new report entitled "Flattening Tax Incentives for Retirement Saving." Authors Barbara Butrica, Benjamin Harris, Pamela Perun, and Eugene Steuerle examine three different options to change the tax treatment of 401(k)s and describe their effects on the annual income distribution of taxes along with the lifetime distribution of taxes and income.

The three options are:

  • Reduce the 401(k) combined employer/employee contribution limit from $51,000 to the lesser of $20,000 or 20 percent of income
  • Expand the saver's credit so middle-income earners can take greater advantage of it
  • Replace the income and payroll tax exclusions for 401(k) contributions with a 25 percent refundable credit

In addition, they show the lifetime effect of eliminating the 401(k) tax preference entirely.

In terms of the annual distributional effect, all of these options are somewhat progressive, particularly the refundable credit, which lowers taxes on average for the bottom 80 percent of earners and raises them on the top one-fifth. The saver's credit expansion lowers taxes more for middle-income taxpayers than lower-income, but it does not benefit high earners. Eliminating or further limiting the preference is highly progressive, particularly at the very top of the income scale.

Percent Change in After-Tax Income by Income Percentile, 2015

Source: TPC

The report shows how the effect on lifetime taxes and income differs by age, race, education, and years worked. Not surprisingly, younger people are more greatly affected by these changes since they have a higher number of years to make/receive 401(k) contributions or be eligible for the saver's credit. With the exception of the refundable credit option, the options have a relatively uniform impact across educational attainment, race, and years worked, although the size of the impact differs for each option. The refundable credit option is more favorable to black and Hispanic savers, those with less education, and those with a shorter work history.

Many tax breaks could be made more efficient, and retirement savings provisions are no exception. The authors note how retirement savings preferences skew benefits towards the top end of the income distribution. The report demonstrates three ways that 401(k)s could be modified to provide a greater benefit to people who need them and a greater incentive to those who are less likely to save without the tax benefit.