Tax-Favored Savings Accounts: Who Gains? Who Loses?

Policy Reports | Taxes

No. 249
Thursday, January 31, 2002
by Jagadeesh Gokhale and Laurence J. Kotlikoff

Taking a Closer Look at the Components of Tax Deferral

Table VI - Percentage Change in Lifetime Taxes from 401(k) Participation under the Old Tax Law

"The Social Security benefit tax is actually a tax on other income."

Table VI considers a couple that has $50,000 in total initial annual income and earns a 6 percent real pretax rate of return on its investments both inside and outside the 401(k) accounts. The table is based on the tax law prior to the 2001 legislation and shows the percentage change in lifetime total tax payments as a result of making maximum contributions to 401(k) accounts. The first row assumes the couple is not covered by Social Security, has no home, no children and pays no college tuition or life insurance premiums.3 The remaining rows add in each of these elements.

Factors Affecting Lifetime Taxes for an Average-Income Family. If the couple has only labor earnings, 401(k) participation is a terrific deal, delivering a 26.2 percent reduction in lifetime tax payments. However, once Social Security is included in the scenario, these gains decline dramatically. The reason is the federal income taxation of Social Security benefits.

The tax on Social Security benefits actually is a tax on other income. The tax is determined by a complicated formula that taxes no benefits if a special measure of income is below a base threshold, taxes up to half of benefits for income falling between this base threshold and a higher threshold, and taxes up to 85 percent of benefits for income falling above the higher threshold.4 For single filers these limits are $25,000 and $34,000 respectively. For joint filers they are $32,000 and $44,000 respectively. Congress has intentionally chosen not to index these thresholds. Hence, over time, an ever-larger portion of the elderly will find they are paying federal income taxes on 85 percent of their Social Security benefits.

"A number of tax law provisions affect the attractiveness of tax-deferred savings."

The further addition of home ownership to the case transforms 401(k) participation into a roughly break-even proposition. The reason is that 401(k) participation lowers tax brackets when young - because taxes on 401(k) contributions are deferred - and consequently reduces the tax savings from deducting mortgage interest payments. If children are also added to the equation, 401(k) participation turns, on balance, into a bad deal because the value of the tax exemptions for children is reduced when the couple's tax brackets are lowered in their child-raising years.

Finally, if the couple also opts to pay its children's college tuition, 401(k) participation really begins to hurt; specifically, it raises the couple's lifetime taxes by 1.1 percent. How does paying college tuition interact with 401(k) participation? Because it pays college tuition, the couple saves less and brings less regular wealth into retirement. As a result, 401(k) withdrawals during retirement generate a bigger increase in tax brackets than occurs when there is more other taxable income, including taxable capital income.

To further clarify the importance of Social Security benefit taxation, the last row of Table VI considers how the household with Social Security benefits and payroll taxes, children, housing, college tuition payments and life insurance premiums would fare from 401(k) participation were there no federal income taxation of Social Security benefits. In this case, participation lowers lifetime taxes by 2.3 percent. The awful conclusion is that federal income taxation of Social Security benefits is sufficient to change 401(k) participation from a good deal to a bad one for moderate-income households.

The Impact of Changing Social Security Benefit Taxation. How would the gains from 401(k) participation change if Congress were to index for inflation the threshold limits that determine taxable Social Security benefits? For the $50,000 household, inflation indexing raises the nominal values of the thresholds and eliminates Social Security benefit taxation in the no-participation case. But with participation, indexing the limit makes no difference to Social Security benefit taxation.

"Eliminating Social Security benefit taxation is a better option for 401(k) savers."

The reason is that the 401(k) withdrawals are so large that non-Social Security taxable income exceeds the top limit even if that limit is inflation-indexed. Indeed, despite the indexation of the thresholds, the full 85 percent of Social Security benefits remains taxable. Since indexing lowers the Social Security benefit taxes paid by the non-401(k) participating household and leaves unchanged the taxes paid by the 401(k) participating household, indexation makes participating in a 401(k) an even worse choice. A better option (for 401(k) holders) is to eliminate Social Security benefit taxation altogether.

Tax Bracket Indexing. Indexing federal income tax brackets to nominal wages rather than the price level is another policy we considered. This assumption precludes real bracket creep and means that our households will be in lower tax brackets in retirement. Nonetheless, this assumption makes little difference to calculated gains and losses from 401(k) participation.

Reducing Contributions. If fully participating in 401(k) plans is a bad deal for low-income families, how would they fare if they reduced their contributions by 50 percent? The answer is much better. Another way to limit contributions is to stop contributing after a certain number of years, or to delay the onset of contributions. Either practice can transform 401(k) participation into a much better deal for those with lower incomes.

The fact that low- and moderate-income families are likely to do better contributing less than the maximum allowable amounts (together with the severe borrowing constraints they are likely to face in making maximum contributions) helps explain the findings that 401(k) participants typically contribute only about 9 percent of their earnings to their plans, although the firms offering 401(k) plans typically permit participants to contribute up to 13 percent of their earnings.5

Read Article as PDF