EFFECTS OF TAXING SAVINGS
January 5, 1996
Individual Retirement Accounts (IRAs) and 401(k) plans were introduced in the early 1980s to encourage saving by allowing individuals to make tax-deductible contributions and accumulate interest tax-free until withdrawn.
Studies show that such plans increased overall savings, and that reducing the tax advantages of such saving has reduced total savings. The result of taxing savings more is that people have less secure retirements, and economic growth is limited.
In the case of IRAs, the effect on saving was dramatic:
- Contributions to IRAs grew from $5 billion in 1981 to about $38 billion in 1986, accounting for 30 percent of the total saving by individuals that year.
- The Tax Reform Act of 1986 eliminated the tax deductibility of IRA contributions for families with annual incomes over $40,000 who were covered by an employer's pension plan.
- By 1990, annual contributions to IRAs fell to less than $10 billion, and participation fell from more 15 percent of income tax filers in 1986 to only 4 percent in 1990.
The 1986 act also reduced savings in 401(k) programs by lowering the limit on employee contributions from $30,000 to $7,000 (which may or may not be matched by the employer). However, unlike IRAs, the tax advantages of 401(k) plans weren't limited by participants' income. Thus, annual employee contributions to 401(k)s still climbed to $51 billion in 1991, with almost 25 percent of families contributing.
Economic research also indicates that:
- If the IRA income limit were raised, one-half to two-thirds of the increase in savings would come from a decrease in current consumption, about one-third from tax savings and only 20 percent, at most, from other savings.
- Contributors to IRAs and 401(k)s increased their total financial assets between 1984 and 1991, with no decrease in other financial assets.
- During the same period, the assets of noncontributors fell, regardless of their income group.
Finally, comparing the savings of those eligible for 401(k) programs with the ineligible shows that at the same income level, although other financial assets were similar, the eligible group had greater financial assets than the ineligible, due to their 401(k) savings.
Source: David A. Wise, "Do Retirement Saving Programs Increase Saving?" NBER Reporter, Fall 1995, National Bureau of Economic Research, 1050 Massachusetts Avenue, Cambridge, MA 02138, (617) 868-3900.
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