Biggest Help for Middle Income Boomers is Social Security Changes

Urban Institute researchers Barbara A. Butrica, Karen E. Smith, and Eric J. Toder, in a paper prepared for the Center for Retirement Research at Boston College, also point out, however, that changes in retirement plan contribution limits and shifts in tax rates on capital gains and dividends will give the most profound boost to the highest income boomers.

“Tax policy directly affects the amount of wealth individuals can accumulate during their working years and, for a given amount of wealth, the living standards they can enjoy in retirement,” the researchers wrote. “Traditionally, Social Security benefits, tax-favored defined benefit plans and retirement saving accounts, and savings accumulated outside of tax-favored accounts have been viewed as the ‘three-legged stool’ of sources of retirement income. How tax policies evolve in the future will affect retirement income from all three sources.”

Butrica, Smith, and Toder reach their conclusions after studying three possible tax law changes and the retirement income effects they would have on Boomers at age 67:

• tax preferences for deferred contribution plans,
• the taxation of equity investment income (capital gains and dividends) outside of retirement plans, and
• the income tax treatment of Social Security benefits.

When it comes to changing plan contribution limits, the researchers find that restoring the pre-2001 contribution limits (indexed for inflation) mostly affects high-income retirees (who were high earning workers), but has very little effect on their after-tax incomes because, even at high incomes, very few workers are currently constrained by the limits.

Extending the tax cuts on dividends and capital gains enacted in 2003 past their expiration date (the end of 2010) would have larger aggregate benefits for older boomers (born between 1946 and 1950) and smaller aggregate benefits for younger boomers (born between 1960 and 1964) than increasing contribution limits, but the benefits would also be concentrated among higher-income retirees, who have the most capital gains and dividends (and had the most gains and dividends in their working years).

Finally, shifting the thresholds for taxing Social Security benefits mostly affects middle-income retirees. Specifically, the researchers examine indexing the thresholds for taxing benefits to changes in the CPI through 2017 (and to wages after 2017) and eliminating the thresholds completely and taxing all benefits. Both changes have less effect on low-income and high-income than on middle-income retirees. Low-income retirees do not benefit much from indexing because most of them do not pay tax on their benefits even with the unindexed thresholds.

Younger boomers have up to 18 years longer than older boomers to accumulate wealth prior to age 67, so policies that raise or lower after-tax returns on saving affect them relatively more, the researchers said.

Indexing Social Security thresholds for inflation also affects younger boomers more than older boomers because younger boomers reach age 67 later, after indexing has had more years to change threshold amounts before taking benefits. The proposal to tax 85% of all benefits with no thresholds, however, increases taxes more for older boomers than for younger because under current law, which does not index thresholds, a larger share of younger boomers’ benefits will already be taxable over time, making a move to full inclusion less of a change for them.

“As policymakers are forced to confront shortfalls in Social Security financing, they could consider income tax changes as an alternative to or in conjunction with reducing benefits or increasing payroll taxes,” the researchers conclude. “Different income tax changes, however, will have substantially different effects on the income distribution of future retirees.’

The paper is available at http://crr.bc.edu/images/stories/Working_Papers/wp_2008-3.pdf.