By Alicia H. Munnell
Expanding Auto-IRAs and Saver Credit Is the Real Way to Increase Savings
A previous version of this column misrepresented the Treasury Department’s estimate of tax expenditures. It has been corrected.
I just reviewed a manuscript where, again, the authors proposed changing the tax incentive for retirement savings from a deduction to a credit. I used to push this idea myself, but now think it’s a diversion that could increase revenue loss for the treasury and wouldn’t do much to increase savings.
Let’s put him to rest.
A little background. Retirement savings according to the legislation in force are fiscally advantageous. Employers and individuals receive an immediate deduction for contributions to traditional pension plans, and participants pay no tax on investment returns until benefits are paid at retirement. The favorable tax treatment significantly reduces lifetime taxes for those who receive part of their compensation as contributions to SHY pension plans compared to those who receive all of their income as cash wages.
Favorable treatment of pension plans costs the Treasury the difference between the present value of foregone revenue and the present value of future taxes for activities undertaken in a given year. The Treasury estimate for 2021 was $187 billion, of which about two-thirds is attributable to 401(k)-type plans. These are big numbers.
These tax incentives pose two problems. First, they give the highest reward to high earners. If a single person in the top tax bracket contributes $1,000, he saves $370 in tax. For a single person in the 12% tax bracket, that $1,000 deduction is only worth $120. It really doesn’t make sense to make the size of the incentive dependent on SHYings earnings.
Second, it is not certain that tax incentives actually encourage people to save more. A study of Danish data found that around 85% of people are “passive” savers who pay little attention to tax incentives. Only 15% are “active” savers who respond to tax subsidies; but they transfer their money from one account to another rather than increasing their total savings.
In response to these questions, many policy experts have suggested replacing the deduction with a refundable credit. The Biden campaign has suggested that a 26% tax credit would be revenue neutral and encourage more low-wage workers to save. I am no longer convinced that either conclusion is correct.
In terms of cost, the credit deduction proposal simply seems to shift part of the tax expenditure from high income to low income. However, on closer inspection, it could lead to a greater loss of income if high earners put all their new savings into Roth 401(k)s/IRAs, which are unaffected by the proposal. That is to say that high incomes would benefit from the same tax advantages as at present, and that tax expenditures for low incomes would increase. In short, while a credit would almost certainly be the way to structure a savings incentive if the country was starting from scratch, such a change – given the existing retirement infrastructure – could cost the Treasury more.
More importantly, switching from a deduction to a credit would do little to encourage saving by low-wage workers. Low-income people who don’t participate in a 401(k) plan when offered one are only a tiny part of the retirement savings problem, and most could be sucked into membership-based plans. automatique.
The real challenge is that most low- and middle-income people are not covered by a plan at work (see Figure 1). This lack of coverage is currently being addressed in some states through self-IRA initiatives, whereby employers without a plan must automatically enroll their employees in an IRA. We need federal legislation to make self-IRAs universal.
Interestingly, since Roth IRAs are the default in self-IRA programs and, as noted, Roths are unaffected by the credit deduction proposal, low-income individuals participating in these programs would not benefit. no such change at all.
In addition to expanding coverage for low- and moderate-income people, we need to increase their savings by expanding savings credit and making it refundable. Saver’s Credit specifically targets the group that needs help and could be employed in conjunction with Roth IRAs in state self-IRA programs. SECURE 2.0 is taking steps to extend the saver’s credit but does not plan to make it refundable.
In short, universal IRAs along with an expanded/redeemable savings credit are the way to increase savings for low-income people – without fiddling with the tax code.
-Alicia H. Munnell
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