Key Questions: Is the Tax Preference for my 401(k) Safe?
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There’s been a lot of hype around a recent research study that makes the case that the tax preferences for saving in retirement plans are expensive, and the tax revenue should be reallocated to fixing Social Security’s finances. Some are worried about what this could mean for their 401(k) plans at work. So, I thought I’d take a look at the merits of this claim.
401(k) and other defined contribution plans serve as the primary retirement savings vehicle for many Americans. There are other retirement savings vehicles, like defined benefit plans, individual retirement accounts, and self-employed plans. However, the focus has been on 401(k) and other defined contribution plans because they make up nearly two-thirds of the related tax preference revenue lost.
Workplace retirement plans have tax deferral benefits. Employees are not currently taxed on their own or their employer’s contributions or on the investment earnings on their retirement account balances. Instead, they defer the taxes until money is withdrawn during retirement, at which time both the contribution and investment earnings are taxed as ordinary income. Not taxing income now that is saved for retirement helps avoid the double taxation of income for those who choose not to consume it immediately.
A recent research study by Andrew Biggs and Alicia Munnell published by the Center for Retirement Research at Boston College1 says that these tax benefits for retirement plans are costly to the government, reducing federal income tax revenues by about $185 billion in 2020. The largest bulk of the tax expenditures was from defined contribution employer plans. Some argue that these tax preferences haven’t encouraged greater retirement savings across the income spectrum, instead largely benefiting higher-income earners vs. their lower-income counterparts. Biggs and Munnell argue that these tax expenditures do not accomplish a broader social goal like increasing retirement savings or expanding the share of workers covered by a retirement plan. Other research studies have found that more passive tools, such as automatic enrollment, which doesn’t rely on individuals to take action to increase savings, may play a bigger role in encouraging greater savings for retirement.
Biggs and Munnell go on to recognize that there is an opportunity for policymakers to re-allocate the tax revenue from 401(k) tax deductions to fix Social Security’s long-term funding gap, which benefits more than just the high earners. I have written about the state of the Social Security system in my annual update on the Social Security Trustees report. The latest update, 2023 Social Security Trustees Report: Combined Trust Fund Projected to Deplete One Year Earlier, indicated that the funds would be insolvent in the early-to-mid-2030s and would result in automatic benefit cuts for future Social Security beneficiaries if Congress does not act.
Whether the tax preference or subsidies for retirement savings accounts increase savings for retirement is a policy that has been researched much in the past. Again, it was the publication of a recent research study by Biggs and Munnell that has caught the attention of the media.
A few scholars have registered their opposition to this proposal. These scholars do believe that tax-advantaged retirement accounts do increase private savings and create broader economic benefits that outweigh the temporary tax revenue loss. There is some literature that indicates that tax-advantaged retirement accounts do result in net new personal savings.
The takeaway is that although this new proposal has received a lot of media hype, there are also quite a few scholars that oppose this proposal. While there might not be imminent action to be taken by clients now, clients may want to know what this would mean for their financial plans. We can model the impact that the elimination of the tax-preference for future contributions to a 401(k) and similar workplace retirement plans can have on a financial plan. Future contributions, by both employer and employee, to a retirement plan could be modeled to be made on an after-tax basis. It’s worth it to stress-test a financial plan for some comfort level, but I'm not sure I would lose sleep over this proposal just yet.
For more information, please contact your advisor.