Federal budget hawks eyeing tax incentives for 401(k)s should take note: low-wage workers get a better deal out of these plans than what was previously thought.
It's estimated revenue loss associated with contributions to IRAs and 401(k)s will exceed $1 trillion over the next decade. Tax reformists have been looking for ways to justify scaling back incentives and have often cited a plan flaw that results in middle- and lower-income earners getting the short end of the tax stick.
William Gale, a senior fellow at the Brookings Institution explains: if two taxpayers are both contributing $6,000 to a 401(k), and one has high income and faces a marginal tax rate of 35 percent, by contributing to the 401(k), she reduces taxes owed by $2,100 (35 percent of the $6,000 contribution). The other, with relatively low income, is in the 10 percent tax bracket, so the 401(k) contribution only reduces taxes by $600.
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"The current system of tax incentives for retirement savings is flawed," Gale argues. "By providing incentives for contributions through tax provisions that are linked to the marginal tax rates that people owe, current incentives deliver their largest immediate benefits to higher-income individuals in the highest tax brackets."
But new research suggests lower income workers might actually better off – or equally benefitted – in a 401(k) plan than their higher-income colleagues because their wages aren't adjusted as much by the employer that is trying to offset plan contributions with lower wages.
While high-income workers may enjoy a bigger tax break, they also face a "short-term trade-off," writes Howard Gleckman, a tax expert and guest blogger for Forbes. "That's because their employers tend to offset their contributions to these plans by paying them less in wages…while lower-wage workers get less of a tax benefit than their higher-paid colleagues, their wages fall by much less for every dollar their employer contributes to their retirement plan."
As policymakers explore ways to restructure the debt system, they've been warned not to mess around too much with a retirement plan that 55 percent of plan participants rely on as their only means of saving.
"Defined contribution plans, such as 401(k)s, and the IRA rollovers they produce, are the component of retirement security that seems to be generating the most non-Social Security retirement wealth for Baby Boomers and Gen Xers," says Jack VanDerhei, research director for the Employee Benefit Research Institute. "The potential increase of at-risk percentages resulting from (1) employer modifications to existing plans, and (2) a substantial portion of low-income households decreasing or eliminating future contributions to savings plans as a reaction to the exclusion of employee contributions for retirement savings plans from taxable income, needs to be analyzed carefully when considering the overall impact of such proposals."
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