Earlier this week, Republicans in Congress hinted that retirement saving tax subsidies might be cut to pay for the GOP tax plan. President Trump quickly assured the public that there would be no change; Ways and Means Chair Kevin BradyKevin Patrick BradyHouse panel advances key portion of Democrats' .5T bill LIVE COVERAGE: Ways and Means to conclude work on .5T package LIVE COVERAGE: Tax hikes take center stage in Ways and Means markup MORE (R-Texas) disagreed. The back and forth has made some savers nervous.
Folks, either way, your 401(k) is safe. It’s all smoke and mirrors.
The heart of the issue is how workers get a subsidy for saving in a 401(k)-type plan. Under current law, most individuals can immediately deduct up to $18,000 in contributions. (The limit for most people on combined employer and employee contributions is $54,000.) These contributions grow tax-free, and are taxed at regular rates when withdrawn.
The tax benefit comes in the form of “deferred taxes”— retirement savers pay income taxes on their savings upon withdrawal. This usually happens later in life, when taxpayers are retired and in a lower tax bracket.
In 1997, Congress created a new benefit for retirement saving: a Roth IRA. Contributions to Roth-type accounts aren’t immediately deductible, but investment earnings and withdrawals are never taxed.
The plan floated by Republicans would reportedly limit traditional contributions to $2,400 per year, while allowing the rest in Roth-type contributions.
Which is better for savers? It generally depends on the gap between a taxpayer’s working-years tax rate and the tax rate in retirement.
But Congress isn’t trying to improve the retirement saving system, and it certainly isn’t trying to make tough tradeoffs in the tax code. It’s simply paying for its tax cut with illusory savings.
With the just-passed budget resolution, Congress has effectively written itself a $1.5-trillion check to pay for a tax cut. But its plan costs roughly $2.4 trillion, so Congress needs to find the additional $900 billion somewhere.
Enter the gimmicks.
Pushing retirement savings into Roth-type plans shows up as a revenue raiser because more income is taxed today, while the real tax break comes years and decades down the line — when workers retire and don’t pay taxes on their withdrawals. But this lost revenue won’t show up in congressional calculations because it falls outside the 10-year budget window.
This isn’t the first time Republicans have used this trick. In 2006, to help pay for lower tax rates on investment income, Congress created a loophole for wealthy taxpayers to avoid income limits on contributions to Roths.
The tragedy here is two-fold. One, by employing this gimmick, Congress is heaping even more debt onto a bill that will eventually be paid by our kids — as if $1.5 trillion isn’t enough. Two, Congress is squandering the chance to improve the existing retirement saving system.
Retirement saving is a good thing. But our current system doesn’t do a very good job of incenting taxpayers to save more. Every year, taxpayers spend well-over $100 billion in tax expenditures devoted toward boosting saving.
While the results are mixed, a host of academic studies suggest that this is a subpar way to get people to save more, with every $1 in tax incentives boosting total saving by as little as a few cents.
There are better options. We could build on evidence showing the remarkable power of inertia, and facilitate state adoption of “auto IRAs” that automatically enroll workers in a saving plan. We could boost the Savers’ Credit, which gives a modest subsidy to low- and middle-income workers. Or we could give small businesses a more generous credit when offering a retirement plan to their employees.
And unlike the pretend route taken by congressional Republicans, these reforms could be paid for by honest reforms. Congress could cap retirement subsidies after savers have reached enough to secure a comfortable retirement.
Or the up-front benefit could be limited to 28 percent, rather than the maximum of 39.6 percent currently available to high-income taxpayers.
The bottom line is that your retirement accounts are safe. You have no reason to worry. Well, unless you’re a kid today who will get stuck with the bill down the line.
Benjamin Harris is a visiting associate professor at the Kellogg School of Management at Northwestern University and was formerly the chief economist to Vice President Biden.