Tax-Favored Savings Accounts: Who Gains? Who Loses?
Table of Contents
ESPlanner smooths a household's living standard over its life cycle to the extent possible without having the household go into debt. The program has highly detailed federal income tax, state income tax, Social Security payroll tax and Social Security benefit calculators. The federal and state income-tax calculators determine whether the household should itemize its deductions, compute deductions and exemptions, deduct from taxable income contributions to tax-deferred retirement accounts, include in taxable income withdrawals from such accounts as well as the taxable component of Social Security benefits, and calculate total tax liabilities after all applicable refundable and non-refundable tax credits. These calculations are made separately for each year that the couple is alive as well as for each year a survivor may be alive.
The program also takes into account the non-fungible nature of housing, bequest plans, economies of shared living, the presence of children under age 19 and the desire of households to make "off-the-top" expenditures on college tuition, weddings and other special expenses. Finally, ESPlanner simultaneously calculates the amounts of life insurance needed by each spouse to guarantee that potential survivors suffer no decline in their living standards compared with what would otherwise be the case.
ESPlanner calculates time-paths of consumption expenditure, taxable saving and term life insurance holdings in constant (2001) dollars. Consumption in this context is everything the household gets to spend after paying for its "off-the-top" expenditures - its housing expenses, special expenditures, life insurance premiums, special bequests, taxes and net contributions to tax-favored accounts. Given the household's demographic information, preferences and borrowing constraints, ESPlanner calculates the highest sustainable and smoothest possible living standard over time, leaving the household with zero terminal assets apart from the equity in homes that the user has chosen not to sell.
In our use of ESPlanner for this study, we consider how contributing to retirement accounts affects the present values of a household's total tax payments and spending, which is defined as the sum of consumption expenditures, special expenditures, housing expenditures and life insurance premiums.
Assumptions Behind the Calculations
Our analysis considers a number of couples with common attributes and differing annual incomes, ranging from $25,000 to $1 million. Each couple consists of a husband and wife, both of whom are age 25 and live at most to age 95. Each spouse works to age 65 and earns half of the household's total earnings. Real earnings grow annually by 1 percent. Each couple lives in Massachusetts and has no initial assets apart from a home. Each couple has two children. The first is born when the couple is age 25 and the second when the couple is age 30. The market value of each couple's house is set at three times household labor earnings as of age 25.
The couples purchase their homes at age 25 by paying 20 percent down and borrowing the remainder at 8 percent for 30 years. Annual homeowner's insurance, property taxes and maintenance are set at 0.17 percent, 1 percent and 1 percent of house value, respectively. Each child attends college for four years. Couples earning $25,000 per year spend, by assumption, $7,500 per child for each year of college. This college expense is set at $15,000 for couples earning $50,000 and $30,000 for couples earning $100,000 or $150,000. For couples earning $200,000 or more per year, annual college expenses are capped at $35,000. There are no bequests apart from the value of home equity, which the couple chooses not to sell.
Our calculations assume elective employee contributions and employer matching contributions equal to the average of maximum contributions permitted by employer-provided defined contribution plans. Each household's elective contribution is set at 13.5 percent of earnings. The employer-matching contribution is set at 3 percent of earnings. Hence, 401(k) contributions total 16.5 percent of earnings. At this contribution rate, the contribution ceiling limits the household's combined elective and employer contribution to $60,000 at earnings exceeding $363,636.36.6 In modeling the old tax law, we also apply the current $10,500 limit on elective individual contributions and assume that limit also grows with real wages. In modeling the new tax law, we adhere to the increase in nominal contribution limits specified through 2007, but then allow those limits to grow with real wages.7
Our method of determining the lifetime net tax benefit of 401(k) participation is to compare lifetime taxes and spending with and without such participation. But to make the comparison meaningful, we need to ensure that the couple's gross income is the same in both cases. To do so, we increase each spouse's earnings where they don't contribute to a 401(k) plan by the amount the employer contributes to their plan where they do contribute. Hence, in the no-401(k) participation case, this additional income is subject to immediate federal and state income taxation as well as to payroll taxation.