The federal government subsidizes and incentivizes retirement savings through tax benefits for both individuals and employers. The multiplicity 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 from their taxable income the contributions they make. Withdrawals are taxed as 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. However, 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.
The saver’s credit is another mechanism to encourage individuals to save for retirement. It allows taxpayers with low- and moderate-incomes 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 $63,000 for married couples filing jointly and up to $31,500 for singles (in 2018). The thresholds are indexed for inflation. 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 people with low- and moderate-incomes it was designed to help.
Employers can deduct from their taxable income the contributions they make to workers’ retirement accounts, similar to the deduction 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: for example, Simplified Employer Pensions, SIMPLE IRAs, profit-sharing plans, employee stock ownership plans.
The various types of available retirement 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. For employers, plans have different administrative burdens, contribution requirements and limits, IRS reporting requirements.
In addition, individuals with traditional retirement plans (i.e., those in which contributions are deducted from taxable income) must begin withdrawals from those accounts by the time they reach age 70 ½. (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
Design of tax preferences
Policymakers should adopt new and expanded progressive savings incentives. Tax incentives for retirement savings, such as refundable 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 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, making the full amount of the credit available regardless of taxpayer liability, and making it easily able to be claimed on all income tax forms.
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.