Several tax preferences exist to encourage and subsidize retirement savings. These preferences are extended to individual retirement accounts (IRAs) and employer-sponsored savings plans such as 401(k)s; similar tax preferences are available to small businesses that start a retirement plan, and to moderate- to-low income savers through the saver’s credit.
IRAs and employer-sponsored savings plans such as 401(k)s work in one of two ways. With traditional plans, people make contributions to the plans with pretax dollars. The contributions grow tax free. Withdrawals are taxed as income. With Roth plans, people make after-tax contributions and neither growth nor withdrawals are taxed. Under either type of plan people pay less in taxes than if the tax preference did not exist. Traditional and Roth plans have different rules in terms of income limits on participation.
IRAs and employer-sponsored savings plans such as 401(k)s have different rules concerning limits on contributions and conditions under which participants can access the money in their accounts prior to retirement without a penalty. Early withdrawals from both erode retirement savings.
The “saver’s credit” is another mechanism to encourage savings. It allows eligible taxpayers to claim a credit against income tax owed for contributions they made to various retirement savings plans including 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. The credit is available for taxpayers with an adjusted gross income of up to $62,000 for married couples filing jointly and up to $31,000 for singles (in 2017). The thresholds are indexed for inflation.
Many moderate- and low-income people, however, cannot benefit from these tax incentives. People who owe no federal income tax get no benefit from claiming an additional deduction for an IRA contribution, although their contributions do grow tax free. Similarly, because the saver’s credit is nonrefundable, it can be used only to offset tax liability and offers little or nothing to many of the low- and moderate-income people it was designed to help.
Tax Incentives: Policy
Design of tax preferences
AARP supports adoption of new and expanded progressive savings incentives. Tax incentives for retirement savings, such as refundable tax credits, should be established for those who are less likely to save, particularly those with low to moderate incomes; kept at a reasonable cost; designed so that they promote new net savings; and promoted by educational efforts.
Retirement security is of paramount importance. 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 low- and middle-income people, 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.
Provisions that allow early withdrawal of funds from tax-preferred retirement savings accounts for nonretirement purposes undermine the purpose of encouraging saving for retirement. Withdrawals of funds from all retirement vehicles should be restricted.
Congress should improve the saver’s credit by phasing out the credit gradually and smoothly as income increases, increasing the income limits for receiving the credit, and making it easily able to be claimed on all income tax forms.
The full amount of the credit should be available regardless of taxpayer liability. Congress should consider depositing the credit directly into retirement savings accounts as a match for saving