Data & Research November 9, 2011

EBRI: Tax Reform Proposals Likely to Reduce 401(k) Balances

Two recent proposals to change the existing tax treatment of 401(k) retirement plans, if enacted, are likely to result in lower account balances for many 401(k) participants, according to the Employee Benefit Research Institute (EBRI). 
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EBRI reports that currently, the combination of worker and employer contributions to a 401(k) plan is capped by the federal tax code at the lesser of $49,000 per year or 100% of a worker’s compensation (participants over age 50 can made additional “catch-up” contributions). As part of the effort to lower the federal deficit and reduce federal “tax expenditures,” two major reform proposals have surfaced that would change current tax policy toward retirement savings: 

  • A plan recently presented at a Senate Finance Committee hearing that would end the existing tax deductions for 401(k) contributions and replace them with a flat-rate refundable credit that serves as a matching contribution into a retirement savings account.  
  • The so-called “20/20 cap,” included by the National Commission on Fiscal Responsibility and Reform in their December 2010 report, “The Moment of Truth,” which would limit individual annual contributions to either $20,000 or 20% of income, the so-called “20/20 cap.”  

The analysis is based on EBRI’s proprietary Retirement Security Projection Model, and is published in the November 2011 EBRI Issue Brief, “Tax Reform Options: Promoting Retirement Security.”

EBRI determined that the impact of permanently modifying the exclusion of employee contributions for retirement savings plans from taxable income the average reductions in 401(k) accounts at Social Security normal retirement age would range from a low of 11.2% for workers ages 26‒35 in the highest-income groups to a high of 24.2% for workers in that age range in the lowest-income group.

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The impact of the "20/20 Cap” would most affect those with high income (see “Capping Tax-Preferred 401(k) Contributions Would Hurt Workers”). However, EBRI also found the lowest-income group has the second-highest average percentage reductions in retirement contributions, and that younger cohorts would experience larger reductions given their increased exposure to the proposal. For each of the age groups analyzed, the highest-income group shows the largest average percentage reduction in account balance, ranging from 15.1% for the highest-income group for those currently ages 36–45 and falling to 8.6% for the highest-income group for those currently ages 56–65. However, other than for those with the highest income, those in the lowest-income group showed the second-highest average percentage reductions 

"Defined contribution plans, such as 401(k)s, and the IRA rollovers they produce, are the component of retirement security that seems to be generating the most non-Social Security retirement wealth for Baby Boomers and Gen Xers," said Jack VanDerhei, EBRI Research Director and author of the report. "The potential increase of at-risk percentages resulting from (1) employer modifications to existing plans, and (2) a substantial portion of low-income households decreasing or eliminating future contributions to savings plans as a reaction to the exclusion of employee contributions for retirement savings plans from taxable income, needs to be analyzed carefully when considering the overall impact of such proposals."

To view the analysis, visit http://www.ebri.org. 

Data & Research November 9, 2011

Cuts in Social Security Benefits May Not Harm Younger Workers

Despite the fact that most Social Security reform proposals would result in fewer benefits for future retirees, an offsetting gain would be the decrease in payroll taxes needed from younger workers to support the program. 
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According to a study from The National Center for Policy Analysis (NCPA), in some cases, workers would come out ahead with the tax reductions exceeding the Social Security benefit cuts.

The average lifetime single-male income level is calculated in 2011 dollars at $42,886 for a 41-year old and at $51,560 for a 26-year old. The study found that raising a 41-year old middle-income man’s retirement age to 70 would reduce his lifetime benefits by about $60,000. But since his taxes would fall by about $40,000, compared to the taxes necessary to fully fund benefits under the current program, the lower tax burden would offset two-thirds of the benefit loss.

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Raising the retirement age for the 41-year old earning a poverty-level wage would reduce his lifetime benefits by about $26,000, but his lower tax burden offsets about 40% of the benefit loss. For a very high-income worker (16 times the poverty level), the lower tax burden would offset 90% of the benefit loss. Changing the benefit formula to make it less generous actually causes the 41-year old middle-income worker’s taxes to drop by more than the loss of benefits. Under progressive price indexing, his lower taxes exceed his benefit loss by $30,000.

Among 26-year olds, raising the retirement age would reduce a very high-income worker’s taxes by more than the reduction in benefits. For a medium-income earner, the tax reduction would make up for 95% of his benefit loss. The fall in taxes for a poverty-level worker would offset about half of his lost benefits. Progressive price indexing would reduce the tax burden for today’s 26-year olds in every income group by more than their benefit loss, when compared to a fully funded current program.

Changing the benefit formula would reduce the taxes of the highest-income earner by more than the reduction in his benefits. The benefit loss of a medium-wage worker would be almost entirely offset by tax reductions. The poverty-level worker's benefit loss would be offset 85% by lower taxes.

“You can't just focus on the change in benefits,” said co-author Andrew J. Rettenmaier, an NCPA Senior Fellow and Executive Associate Director at the Private Enterprise Research Center at Texas A&M University. "You have to compare the taxes necessary to fully fund any reform."

The study also states that raising the taxable maximum would increase the taxes of very high income workers, but for today's 26-year olds half of the tax increase would be offset by increased benefits the government would have to pay to those same workers. 

"The biggest problem with raising the maximum taxable wage is that it commits the government to a larger program," said Rettenmaier.  "Instead of increasing taxes on higher income workers, the progressive price indexing reform lowers their benefits and reduces the program's size. Progressive price indexing produces similar progressivity as does increasing the taxable maximum, but it is more fiscally responsible in the long-run.”

To view the full study, visit http://www.ncpa.org/pdfs/st337.pdf

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