Whether this is politically wise or not, I will leave to others to discern (OK, it probably isn't), but I figure this is as good a time as any to run through what's wrong with the 401(k), or at least what's wrong with having made it a centerpiece of our country's retirement savings system.
The Republican proposals, as they have leaked out so far, involve reducing the amount of pretax income workers can put in their 401(k) tax accounts from the current $18,000 a year ($24,000 for those 50 and older) to as low as $2,400 a year, and using the budgetary space this would afford for different retirement programs or tax cuts.
It's not clear at this point if workers would still be able to put $18,000 in after-tax income in a Roth 401(k) instead, or if this limit would be ratcheted down, too. If people could simply shift their savings from pre-tax accounts to Roths, this would be a profoundly silly proposal. Regular 401(k)s are taxed as income when the money is withdrawn; Roth withdrawals aren't taxed at all. In the 10-year budget window by which the tax plan is being evaluated, a switch from regular to Roth has a positive impact on revenue. Over the long run, it's a money loser.
But if the idea is to actually reduce the tax deductions for retirement savings, not just shift them across time, it's maybe not so crazy. That's because the use-tax-deductions-to-get-Americans-to-save-for-retirement approach doesn't seem to be doing a good job of getting Americans to save for retirement. Why not? Here are some of the problems:
- The tax incentives don't have much effect. A 2013 study by Harvard's Raj Chetty and a bunch of other economists, most of them Danish, found that a 1999 reduction in the tax subsidy for retirement savings in Denmark had almost no impact on overall retirement savings. People who were saving before still saved afterwards, just not necessarily in a tax-sheltered account.
- They're expensive. The estimated "tax expenditure" on 401(k)s and other workplace defined-contribution accounts adds up to $102 billion this year, according to Congress's Joint Committee on Taxation. By contrast, the earned income tax credit, the biggest benefit for the poor in the tax code, costs $73.4 billion.
- Most American workers don't have them. A recent Census Bureau survey based on tax data found that only 32 percent of American workers are saving anything in a workplace retirement savings account. In many cases, that's because their employers don't offer one -- most private-sector employers don't.
- The benefits are skewed toward those with higher incomes. This is true of any tax deduction (as opposed to tax credits, such as the earned-income credit) because the higher your tax rate, the higher the savings from a deduction. Also, of course, people with higher incomes tend to have more spare money to put in retirement accounts.
- They're inefficient and often poorly managed. Investment returns have generally been lower for defined-contribution plans such as 401(k)s than for traditional defined-benefit pension plans, and administrative costs are higher. There are lots of other problems with pensions and how they're funded, but as professionally managed pooled investments, they have lots of advantages over individual accounts loaded up with mutual funds.
- They individualize risks that are better shared. Because some people die earlier than others, it costs a lot less per person to guarantee an adequate retirement income for 1,000 people than to do it for just yourself. There are ways around this, such as buying an annuity with one's retirement savings. But few people do that, and at present the 401(k) system isn't really set up to encourage it.
So what would be better than giving people a tax deduction for putting money in a 401(k)? Chetty and his co-authors argue that automatic contributions by employers are a much more effective way of encouraging savings. Maybe we should put in a tax subsidy for that. Or there's the bold plan unveiled last year by New School economics professor Teresa Ghilarducci and Blackstone President Tony James to replace the 401(k) with mandatory, professionally managed retirement savings accounts that are automatically converted to annuities at retirement.
Now that is definitely not going to be in this year's tax bill. Let us not dismiss the idea of shrinking that 401(k) deduction just yet, though. I'll admit that, as a heavy user of said deduction, the thought makes me cringe -- and the fact that there are millions like me is why, in the end, I bet Congress will leave be. But there are far more millions of Americans who aren't getting any benefit from the current setup at all. Making it untouchable seems like a bad move.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Justin Fox is a Bloomberg View columnist. He was the editorial director of Harvard Business Review and wrote for Time, Fortune and American Banker. He is the author of “The Myth of the Rational Market.”
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