Tax-Favored Savings Accounts: Who Gains? Who Loses?
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With the Social Security system under financial pressure from the impending retirement of the baby boom generation, the government is trying to encourage additional saving through retirement accounts. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) greatly expands the limits on contributions to tax-deductible accounts, including 401(k), 403(b), Keogh and traditional individual retirement account (IRA) plans. It also raises contribution limits of non-tax-deductible Roth IRAs. These new provisions include:
- Raising from $30,000 to $40,000 the employer plus employee 401(k) and 403(b) contribution limit, or 25 percent of the employee's total compensation, whichever is less.
- Raising from $10,000 to $15,000 by 2007 the 401(k) and 403(b) individual contribution limits.
- The indexation after 2007 of 401(k) and 403(b) individual contribution limits.
- Raising from $2,000 to $5,000 by 2008 the traditional IRA and Roth IRA contribution limits.
- The indexation after 2008 of the $5,000 traditional IRA and Roth IRA contribution limits.
"People can end up with higher lifetime taxez by saving in a tax-deferred plan."
In a less well-known provision, the law provides a significant non-refundable tax credit to low-income families for qualified contributions by workers (but not employers). Couples filing a joint return with an adjusted gross income under $30,000 get a 50-cent tax credit for each dollar contributed up to $2,000. For gross income between $30,000 and $32,000, the credit is provided at a rate of 20 cents per dollar contributed. And for gross income between $32,000 and $50,000, the credit is provided at a 10 cents per dollar rate. There is no credit if gross income exceeds $50,000.
The congressional debate on these provisions proceeded with little discussion of the gains to potential winners. And they certainly included no discussion of the losses to potential losers, since the general presumption is that participating in tax-favored saving vehicles can only benefit workers by reducing their lifetime taxes. As the authors of this paper demonstrated in a recent study, this presumption is correct for high-income families, but not for low- and moderate-income families who participate fully in 401(k) and similar tax-deferred saving plans.1
How can people end up with higher lifetime taxes by saving in a tax-deferred plan? The answer is: Their taxes are raised in old age by more than their taxes are lowered when they are young.
A 401(k) or similar tax-deferred savings account allows workers to delay paying taxes on their current earnings until they reach retirement. Hence, these accounts give workers an interest-free loan on the taxes they would otherwise be currently paying. In addition to this unambiguous tax advantage, most people assume that they will be in a lower tax bracket after retirement. But withdrawals from a 401(k) account, coupled with other retirement income such as Social Security, can push retirees into higher brackets. The result is that increased taxes in retirement can more than eclipse the tax savings from earlier years. This perverse outcome occurs for four reasons:
- First, relatively large withdrawals from 401(k) and other tax-deferred accounts mean that taxable income is much higher in the year they occur. This spurt in income can push the taxpayer into a higher - indeed much higher - tax bracket during retirement than during the working years.
- Second, significant contributions to tax-deferred retirement accounts can mean that taxable income is lower in the year the deposits are made. Since the reduction in income can place the taxpayer in a lower tax bracket, this reduces the value of mortgage interest and other deductions.
- Third, shifting taxable income from youth to old age can substantially increase the share of Social Security benefits that becomes subject to federal income taxation.
- Finally, the government can raise taxes when one retires, and this is highly likely given the large unfunded liabilities in federal entitlement programs.