Does It Pay to Save?

Policy Reports | Taxes

No. 298
Friday, June 01, 2007
by Laurence J. Kotlikoff and David S. Rapson

Executive Summary

Does it pay to save?  The answer is often no.  In fact, penalties for saving are astronomical for some households, particularly young, single-parent and lower-income families.  But these are the very people who need the strongest incentives to save for retirement. 

Determining the effective marginal tax on additional saving is difficult because of the complexity of the tax code and the interaction of different government tax and transfer programs (such as food stamps) that are limited to households below certain income and asset ceilings.  Saving and wealth accumulation can put a family over an asset limit and cost thousands of dollars in lost benefits. 

To calculate the effective marginal tax on saving, this study uses financial planning software that carefully determines tax and transfer payments at each stage of a person's life, based in part on economic choices they make in prior periods.  The model assumes people try to even out consumption over their lifetimes.   

The results:  For single parents with two children, effective marginal taxes on savings are regressive - lower-income households pay higher rates than high-income households.  Furthermore, these households face the highest tax rates at younger ages:

  • A 30-year-old single parent earning $15,000 a year faces an effective marginal tax on saving of 260 percent; for each additional dollar saved, the parent loses $2.60 in additional taxes and foregone government benefits.
  • By contrast, if the same parent earned $250,000, the marginal tax on saving would be only 31 percent.
  • At age 45, a single parent earning $10,000 a year faces an effective marginal tax on saving of 109 percent, compared to 39 percent for one earning $250,000.
  • A 60-year-old earning $15,000 a year faces an effective marginal tax on saving of 41 percent, compared to 36 percent for one earning $250,000.

In contrast to single parents, couples with two children face lower marginal taxes on saving from younger ages through middle age.  However, among 60-year-old couples, those with modest incomes pay the highest marginal tax rates on saving.  Overall: 

  • A 30-year-old couple with two children faces an effective marginal tax on savings ranging from 20.5 percent for a couple earning $20,000 a year to 51.5 percent for those earning $500,000 annually.
  • Similarly, a 45-year-old couple faces effective marginal taxes ranging from 20.1 percent for a couple earning $20,000 to 43.4 percent for one earning $500,000.
  • But among 60-year-old couples whose children have reached adulthood, households earning $20,000 face the highest effective marginal tax rate (38.6 percent), while couples earning $50,000 face a marginal tax of only 22 percent.  

The U.S. fiscal system penalizes young, lower-income households that should be given incentives to save early in life.  There is a federal tax incentive that provides a federal match of up to 50 cents for each dollar saved by a low- to moderate-income family. However, households with a zero or negative tax liability are ineligible for this Saver's Credit.  This is one of the many ways that unrelated provisions of the tax and benefit systems interact to penalize even the most negligible savers.

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