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US Tax Benefits for Retirement Saving: Who Benefits and Why?

January 25, 2016

David C. JohnSenior Strategic Policy AdvisorAARP Public Policy Institute

Coming Attractions

• What is the Purpose of Tax Benefits?• Context: Quick Overview of the US System• Traditional Treatment (EET)• “Roth” Treatment (TEE)• Savers Credit & A Better Savers Credit• Comparing results• Do Tax Benefits Incentivize Saving?

What Is the Purpose of Tax Benefits for Retirement Saving?

• To encourage people to save or save more?

• To increase savings balances (& thus retirement income)?

• Both?

US Tax System

• Extremely complex• 7 marginal tax brackets between 10% and

39.6%. Also capital gains.• Standard deduction + personal exemption +

itemized deductions reduce taxable income• 43% pay no net income tax• Also FICA (Social Security & Medicare) + state

& local income taxes

US Retirement System• Social Security based on wage indexed lifetime earnings

– Benefits increase annually by prices– Average benefit about $16,000 – range $5k to $35k

• Few private sector DB plans• Both EET and TEE retirement savings plans available• About half have employer-sponsored plans• Rest can save in Individual Retirement Accounts (IRAs)

– Only about 1-in-20 actually do• Funds can be accessed early (may be a tax penalty)• No tax-free lump sum and few annuitize

Traditional (EET)

• Reduces taxable income & shows a deduction on paycheck. Assumes lower tax bracket in retirement.

• No income limit in employer or individual plan.

• Withdrawals before age 59½ taxable + 10% penalty.

Traditional (EET) - Benefits

• Easy to understand. Benefit can be seen throughout the year.

• Deduction is an incentive to save for all income levels regardless of actual benefit.

• Deduction especially valuable if no employer plan.

Traditional (EET) - Negatives

• Size of benefit depends on marginal tax rate.• If taxpayer has no tax liability, he or she gets

no real benefit.• Wealthy get much more; low income get no

real value.• Benefit increases consumable income – not

savings.

Traditional (EET) – Government Finance

• Reduces revenue today – extremely visible & quantifiable (both now and in the future).

• Tax deferral, not tax exempt. Most lost income eventually recaptured.

• Taxes on internal buildup are collected.

Roth (TEE)

• Created in 1997. Contributions after tax up to contribution limits. All internal buildup and withdrawals tax free.

• No tax on early withdrawal of contributions.• Roth IRA only available up to annual incomes

of $114,000 (single). Roth employer plans available to all income levels.

• Income limit to keep wealthy from using it as a tax shelter.

Roth (TEE) - Benefits

• Simple to understand.• No tax ever on internal buildup.• Lower income do get a benefit.• Upper incomes get an even greater benefit.• Especially used by upper income and upwardly

mobile younger white collar workers.

Roth (TEE) - Negatives

• Upper income can use loophole for unlimited Roth benefit.

• No immediate savings incentive – especially for lower incomes.

• As contributions reduce consumption income, contributions & participation may decline.

Roth (TEE) – Government Finance

• Appears to produce more immediate government income.

• Tax never collected on internal buildup. Foregone future revenue may be huge & growing.

• Wealthy can use to shelter income & assets.• Tax benefit assumes that government keeps its

word.

Savers Credit

• Special additional benefit for lower income savers regardless of tax treatment.

• Provides 50% of up to $2,000 contribution for incomes below $36k. Much lower matches up to family incomes of $61k.

• Only offsets tax liability. If none, then no benefit is paid. Also, must be claimed on long tax forms.

Problems with the Savers Credit

• Few claim the credit or know about it. • Most eligible have no tax liability & use

shorter forms where Savers Credit is not available.

• Credit comes as consumable payment.• No incentive to save as credit comes long after

decision has been made.

A Better Version

• Simple credit available on short tax forms regardless of tax liability.

• Provides 50% credit for contributions that goes directly into the account. Not available for early withdrawal.

• Deposited into the same investment choice as rest of account.

New Version - Positives

• Actually benefits population it is intended to help.

• Builds savings balances and increases retirement incomes.

• Easy to claim. Can be automatic in tax software.

• Growing balance is an incentive to save.

New Version - Negatives

• Revised savers credit has a high budget cost – up to $20 billion/year.

• Savers may not understand that they cannot use early withdrawal for match.

Do Tax Benefits Increase Saving?

• There is evidence that 85% of retirement savers are passive & only 15% are actively involved.

• Passive savers react to automatic enrollment much more than tax incentives.

• Active savers react to tax incentives, BUT…

– Chetty, Friedman, et al., ACTIVE VS. PASSIVE DECISIONS AND CROWD-OUT IN RETIREMENT SAVINGS ACCOUNTS: EVIDENCE FROM DENMARK

What About the Wealthy?

• Very upper income savers reallocate savings according to tax incentives. They do not change the amount saved, just where it goes.

• Lower income savers are more likely to react to a change in take home income.

• They save due to automatic enrollment, but little data on auto into TEE accounts. May stop if they see a significant drop in income.

Title text hereContact Us:

David C. JohnSenior Strategic Policy Advisor

djohn@aarp.org

AARP Public Policy Institute www.aarp.org/ppi

Twitter:@AARPpolicy www.Facebook.com/AARPpolicyBlog: www.aarp.org/policyblog