Retirement Tax Provisions

Background

The federal government subsidizes and incentivizes retirement savings through tax benefits for both individuals and employers. There is a variety of retirement plan options, and their varying requirements can cause confusion and inefficiencies.

For individuals, IRAs and employer-sponsored savings plans such as 401(k)s work in one of two ways. With traditional plans, people can deduct their contributions to the plan from their taxable income. Withdrawals are taxed as regular income. With Roth plans, people pay tax on the contributions, but the withdrawals they make in retirement are not taxed. Under either type of plan, the contributions grow tax-free, and most people pay less in income taxes than if the tax preference did not exist. People who owe no federal income tax get no benefit from claiming an additional deductionReduction in the amount of income that is subject to tax. A dollar of a deduction reduces taxes by only a fraction of a dollar, as determined by the taxpayer’s applicable tax rate for an IRA or 401(k) contribution. However, their contributions do grow tax-free.

The saver’s credit allows taxpayers with low and moderate incomes to claim a credit against income tax owed for contributions they make to various retirement savings plans. That includes both IRAs and employer-sponsored savings plans such as 401(k)s. The maximum credit equals $1,000 for single filers and $2,000 for joint filers. In 2020, the credit was available for taxpayers with an adjusted gross income of up to $65,000 for married couples filing jointly and up to $32,500 for singles. The thresholds are indexed for inflation. Because the saver’s credit is nonrefundable, it can be used only to offset tax liability. As a result, it offers little or nothing to many of the people with low and moderate incomes it was designed to help.

Employers can deduct from their taxable income contributions made to workers’ retirement accounts. This is similar to the deductionReduction in the amount of income that is subject to tax. A dollar of a deduction reduces taxes by only a fraction of a dollar, as determined by the taxpayer’s applicable tax rate that they can claim for wages and salaries paid to workers. They can also deduct the costs of operating the plan. While 401(k)s and 403(b)s are the most common retirement plans offered by employers, small business owners have additional options. These include Simplified Employer Pensions (known commonly as SEPs), SIMPLE IRAs, profit-sharing plans, employee stock ownership plans. 

The various types of retirement savings plans differ in many ways for both workers and employers. For workers, plans vary in terms of:

  • income limits,
  • limits on contributions,
  • withdrawal rules upon retirement, and
  • conditions under which participants can access the money in their accounts prior to retirement without a penalty.

Penalties for early withdrawals exist because using retirement funds for nonretirement purposes undermines the purpose of encouraging saving for retirement. Penalties can be waived in certain circumstances.

For employers, plans have different administrative burdens, contribution requirements and limits, and Internal Revenue Service reporting requirements.

In addition, individuals with traditional retirement plans must begin withdrawals from those accounts by the time they reach age 72. (Traditional retirement plans are those in which contributions are deducted from taxable income.) Roth 401(k)s are not subject to required distributions until after the death of the owner. This rule ensures that the assets in these accounts do not escape taxation altogether. The Treasury Department uses life expectancy tables to determine the appropriate age threshold for the required minimum distribution (RMD). Those tables have become outdated. Exempting from the RMD assets up to a certain level could help to ensure longer-term retirement savings.

RETIREMENT TAX PROVISIONS: Policy

RETIREMENT TAX PROVISIONS: Policy

Design of tax preferences

Policymakers should adopt new and expanded progressiveIn taxation, a situation in which people with lower income pay a smaller percentage of their income than do people with higher income. savings incentives.

Tax incentives for retirement savings, such as refundableA tax credit whose full amount is paid even if it exceeds the amount of taxes owed. tax credits, should be established for those with low to moderate incomes and others who are less likely to save. They should be kept at a reasonable cost, designed so that they promote new net savings, and promoted by educational efforts.

Any changes to retirement savings incentives should ensure that:

  • the tax benefits are more progressively and equitably distributed and result in greater net savings than those in the current tax code;
  • tax benefits are targeted to people with low and middle incomes, who are less likely to increase their savings without the incentive; and
  • incentives for employers to make retirement savings mechanisms available in the workplace are not undermined.

Withdrawals of funds from all retirement vehicles should be restricted.

Saver’s credit

Congress should make improvements to the saver’s credit. The credit should be phased out gradually and smoothly as income increases. Income limits for receiving the credit should be increased. The full amount of the credit should be made available regardless of taxpayer liability. People should be able to claim the credit regardless of which income tax form they use.

Congress should consider depositing the credit directly into retirement savings accounts as a match for savings.

Required minimum distributions

Minimum distribution requirements for retirement savings should periodically be examined to reflect changes in life expectancy and income needs at older ages while ensuring the collection of deferred revenue streams.