Further Limit Annual Contributions to Retirement Plans

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 established 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. Contributions to such plans cannot be excluded from taxable income; instead, the participant benefits by not paying tax on the investment income, either as it accrues or when it is withdrawn.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 participants 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 contributions were 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 benefit can be higher or lower than under a Roth plan, depending on the difference between the participant's tax bracket at the time contributions are made and when withdrawals are made.)

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. (For some forms of investment income such as capital gains, lower tax rates apply in each tax bracket, and the savings are smaller.)

People under the age of 50 may contribute up to $18,000 to 401(k) and similar employment-based plans in 2016; participants ages 50 and above are also allowed to make "catch-up" contributions of up to $6,000, enabling them to make as much as $24,000 in total contributions in 2016. In general, the limits on a person'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 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 $48,000 in a single year. Employers may also contribute to their workers' defined contribution plans, up to a maximum of $53,000 per person in 2016, less any contributions made by the employee.

In 2016, combined contributions to Roth and traditional IRAs are limited to $5,500 for taxpayers under the age of 50 and $6,500 for those ages 50 and above. The tax deduction for contributions to a traditional IRA is phased out above certain income thresholds if either the taxpayer or the taxpayer's spouse is covered by an employment-based plan (but nondeductible contributions—which still enable a taxpayer to defer taxes on investment gains until they are withdrawn—are allowable at any income level). Allowable contributions to Roth IRAs are phased out above certain income levels, and no contributions are permitted at incomes above $194,000 for married taxpayers filing joint returns, $10,000 for married taxpayers filing separate returns, and $132,000 for unmarried taxpayers. However, that limit can be circumvented by making a nondeductible contribution to a traditional IRA and then converting the traditional IRA to a Roth IRA before any investment income can accrue. Annual contribution limits for all types of plans are adjusted, or indexed, to include the effects of inflation but only in $500 increments ($1,000 increments in the case of the overall limit on contributions to defined contribution plans).

Under this option, a participant's maximum allowable contributions would be reduced to $16,000 per year for 401(k)–type plans and $5,000 per year for IRAs, regardless of the person'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 $53,000 per year to $47,000. Finally, conversions of traditional IRAs to Roth IRAs would not be permitted for taxpayers whose income is above the top threshold for making Roth contributions.

The lower limits on contribution amounts would increase revenues by $96 billion from 2017 through 2026, the staff of the Joint Committee on Taxation estimates. The constraints on Roth conversions would reduce revenues by $4 billion over that period, for a combined total of $92 billion.

The revenue reduction associated with constraining Roth conversions largely reflects the loss of tax payments that would otherwise be due at the time of conversion. But the longer-term effects on revenues of that aspect of the option would probably be different. The loss of Roth benefits for those above the threshold would result in the taxation of more investment income—whether the nondeductible contributions remained in the traditional IRA or were diverted to a taxable account. Because balances can be converted only once, the tax consequences of disallowing some conversions would begin to decline as the demand for conversions was gradually satisfied. Over the longer term, revenues gained by taxing more investment income would probably outweigh those lost from disallowing conversions.

The option would also affect federal outlays, but by much smaller sums. Reducing the amount that employers are allowed to contribute would lead to an increase in taxable wages, the base from which Social Security benefits are calculated, and thus would increase spending for Social Security by a small amount. (The estimates shown here do not include any effects on such outlays.) The changes in contributions by employees would not affect the wage base for Social Security.

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 tax-preferred 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 9 percent of participants in calendar year 2010 (the most recent year for which such data are available)—but of those affected, 42 percent had income in excess of $200,000 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 contribution limits imposed under 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 taxpayers who are constrained by the current limits on contributions are most likely to be those who can fund the tax-preferred accounts by using money they have already saved or would save anyway; in that case, the tax preference provides benefits to the people involved without boosting aggregate saving. Thus, the option would increase public saving—by reducing the deficit—at the cost of very little private saving.

Finally, the option's constraints on Roth conversions would reduce the complexity and improve the transparency of the tax system, making it easier for participants and nonparticipants alike to understand the tax ramifications of Roth accounts. Furthermore, the financial institutions managing the accounts would incur, and pass on to participants, fewer administrative costs. (Even greater transparency could be realized by eliminating the income thresholds and allowing everybody to contribute directly to a Roth IRA, but that would reduce revenue over the long term.)

The main argument against this option is that it would reduce the retirement saving of some lower- and -moderate-income people. Eliminating the extra allowance for catch-up contributions in particular 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 to the owners of providing such plans were outweighed by the cost of administering them. To the extent that such plans were terminated, employees would then have to rely on IRAs, which would lead some to save less because of the lower contribution limits.