|(Billions of dollars)||2014||2015||2016||2017||2018||2019||2020||2021||2022||2023||2014-2018||2014-2023|
|Change in Revenues||4.5||6.7||7.3||8.1||8.7||9.4||10.0||10.8||11.3||12.0||35.3||88.7|
Source: Staff of the Joint Committee on Taxation.
Note: This option would take effect in January 2014. To the extent that the option would affect Social Security payroll taxes, a portion of the revenues would be off-budget. In addition, the option would increase outlays for Social Security by a small amount. The estimates do not include those effects on outlays.
Current law allows taxpayers to make contributions to certain types of tax-preferred retirement plans up to a maximum annual amount that varies depending on the type of plan and the age of the taxpayer. The most common such vehicles are defined contribution plans (any plan that does not guarantee a particular benefit amount upon retirement) and individual retirement accounts (IRAs). Defined contribution plans are sponsored by employers. Some—most commonly, 401(k) plans—accept contributions by employees; others are funded entirely by the employer. IRAs are maintained by the participants themselves.
Most of the tax savings associated with retirement plans arise because the investment income that accrues in the account is either explicitly or effectively exempt from taxation. That is clearest in the case of Roth retirement plans—both IRAs and 401(k)s—which do not allow contributions to be excluded from taxable income. Instead, the taxpayer benefits by not paying tax on the investment income, either as it accrues or when it is withdrawn. More traditional types of tax-preferred retirement plans allow taxpayers to exclude contributions from their taxable income and defer the payment of taxes until they withdraw funds. If the taxpayer is subject to the same tax rate that applied when the contribution was made, the value of the deduction is offset by the tax on withdrawals. The actual tax benefit is equivalent to that provided by Roth plans—effectively exempting investment income from taxation. (In the traditional structure, however, the tax benefits can be higher or lower than under a Roth plan depending on the tax bracket participants are in when they retire.)
The value of the tax exemption for investment earnings increases with the participant’s income tax rate. Thus, a worker in the 15 percent tax bracket saves 15 cents on each dollar of investment income accrued in his or her retirement plan; however, an employee in the 35 percent tax bracket avoids taxes equal to 35 cents per dollar of investment income. (If the investment income is in the form of capital gains, lower tax rates apply, but they are still graduated by income.)
Individuals under the age of 50 may contribute up to $17,500 to 401(k) and similar employment-based plans in 2013; participants ages 50 and above are also allowed to make “catch-up” contributions of up to $5,500, enabling them to make as much as $23,000 in total contributions in 2013. In general, the limits on an individual’s contributions apply to all defined contribution plans combined. However, contributions to 457(b) plans, available primarily to employees of state and local governments, are subject to a separate limit. As a result, employees who are enrolled in both 401(k) and 457(b) plans can contribute the maximum amount to both plans, thereby allowing some people to make tax-preferred contributions of as much as $46,000 in a single year. Employers may also contribute to their workers’ defined contribution plans, up to a maximum of $51,000 per person in 2013, less any contributions made by the employee.
In 2013, contributions to IRAs are limited to $5,500 for taxpayers under the age of 50 and $6,500 for those ages 50 and above. The amount of such contributions that is tax deductible is phased out above certain income thresholds if either the taxpayer or the taxpayer’s spouse is covered by an employment-based plan. Annual contribution limits for all types of plans are adjusted, or indexed, for inflation but increase only in $500 increments.
Under this option, individuals’ maximum allowable contributions would be reduced to $15,500 per year for 401(k)–type plans and $5,000 per year for IRAs, regardless of a taxpayer’s age. The option would also require that all contributions to employment-based plans—including 457(b) plans—be subject to a single combined limit. Total allowable employer and employee contributions to a defined contribution plan would be reduced from $51,000 per year to $46,000. If implemented, the option would increase revenues by $89 billion from 2014 through 2023, the staff of the Joint Committee on Taxation estimates. The option would also affect federal outlays, but by much smaller sums. Reducing the amount that employers are allowed to contribute would increase taxable wages, the base from which Social Security benefits are calculated, and thus would increase federal spending for Social Security by a small amount. Contributions by employees are already included in the wage base for Social Security. (The estimates shown here do not include any effects on such outlays.)
One argument in favor of this option centers on fairness. The option would reduce the disparity in tax benefits that exists between higher- and lower-income taxpayers in two ways. First, those directly affected by the option would make fewer contributions and accrue less taxpreferred investment income, so the greater benefit of the exemption to those in higher tax brackets would be reduced. Second, the option would affect more higher-income taxpayers than lower-income taxpayers. The limits on 401(k) contributions affect few taxpayers—only 5 percent of participants in calendar year 2006 (the most recent year for which such data are available)—but of those affected, 69 percent had income in excess of $160,000 that year. The option also would level the playing field between those who currently benefit from higher contribution limits (people ages 50 and over and employees of state and local governments) and those subject to lower limits.
In addition to enhancing fairness, the option would improve economic efficiency. A goal of tax-preferred retirement plans is to increase private saving (although at the cost of some public saving). However, the higher-income individuals who are constrained by the current limits on contributions are most likely to be those who can fund the tax-preferred accounts using money they have already saved or would save anyway; in that case, the tax preference provides benefits to the individuals involved without boosting aggregate saving. Thus, the option would increase public saving—by reducing the deficit—at the cost of very little private saving.
The main argument against this option is that it would reduce the retirement saving of some people, particularly those who find it difficult to save because of income constraints or family responsibilities. Although only 5 percent of workers with income under $80,000 contributed to IRAs in 2006, more than one-third contributed the maximum amount permitted. Those workers generally have relatively little in accumulated savings and are more likely to respond to the incentive to save than are people in higher-income groups. Eliminating the extra allowance for catch-up contributions would adversely affect those ages 50 and over who might have failed to save enough for a comfortable retirement while raising their families. The amount that they could contribute to tax-preferred retirement accounts would be cut at precisely the time when reduced family obligations and impending retirement make them more likely to respond to tax incentives to save more.
Finally, further limiting total contributions to a defined contribution plan would create an incentive for some small businesses to terminate their plans if the tax benefits of the plan to the owners were outweighed by the cost of administering it. To the extent that plans were terminated, employees would then have to rely on IRAs, which would lead some to save less because of the lower contribution limits.