In April alarm bells went off—briefly—in the world of people who keep a close watch on 401(k) retirement plans. According to the Wall Street Journal, Gary Cohn, director of the White House National Economic Council, discussed with senators whether to drop the tax break U.S. savers can get when putting money into a workplace retirement plan, while letting earnings and withdrawals be tax-free. The Trump administration later said it wasn’t planning to change the 401(k) as it seeks ways to fund the cut in tax rates it’s promised.
The discussion was a reminder that retirement plans are very much creatures of the U.S. tax code. Which makes now a good time to ask: After a certain point, are tax incentives really the best way to get people to save more for retirement? Designing retirement plans that are easy for more people to use could be just as powerful.
“Tax breaks play a huge part in our retirement system, and the money we spend is rising a lot, especially as the boomers come up toward retirement,” says John Friedman, associate professor of economics at Brown University. By “the money we spend,” he means forgone tax revenue. For 401(k)s and similar employee plans, the expenditure is more than $100 billion a year.
The people most likely to respond to tax breaks, says Friedman, are “active savers” who think hard about saving and where it goes. These people mostly take advantage of tax breaks not by saving more, but by taking money they would have put in a taxable brokerage account and putting it in a 401(k) plan instead, he says. Friedman estimates active savers make up 15 percent to 20 percent of all savers.
The breaks tend to benefit the most affluent workers, who can afford to save more for retirement and who face higher income taxes, says Christopher Howard, professor of government and public policy at the College of William & Mary. That doesn’t mean affluent savers can’t use some help, says Olivia Mitchell, a professor at the University of Pennsylvania’s Wharton School. Social Security benefits replace a lower share of pretax income for higher earners, so they have to save more to avoid facing tighter budgets in old age.
Still, if the aim of retirement policy is to get a broader segment of Americans to save, there’s a long way to go. About half of households with people age 55 and older have no retirement savings, according to the U.S. Government Accountability Office. Having access to a workplace plan greatly increases the odds of someone saving—and the tax break encourages many employers to set one up, since high-paid employees demand it. But once a 401(k) is running, it’s smart design that draws people in. Fewer than 40 percent of employers automatically enroll their employees in a plan. Left to their own devices, about half of workers sign up. With auto-enrollment, employees can opt out, but in fact about 90 percent of workers stick with it. The popular default for employee contributions, however, is only 3 percent of salary. Between the employee’s saving and an employer’s match, it should top 15 percent, according to David Blanchett, Morningstar Inc.’s head of retirement research.
Just a third of workers save in a 401(k) or similar plan, in part because many don’t have access to one. Traditional individual retirement accounts, originally created to help employees without workplace plans, are most widely used by people rolling over 401(k) assets after leaving a job, says Alicia Munnell, director of the Center for Retirement Research at Boston College. Rollovers account for about 87 percent of new money coming into IRAs each year.
IRAs aren’t very effective in sparking savings because they don’t get that extra nudge from the human resources department. With saving, “you get most of the action from auto-enrollment and payroll deduction,” says Munnell. The favorable tax treatment IRAs receive does give them a halo effect, signaling that retirement saving is important. Several states, including California and Illinois, have moved to create auto-IRAs. Employers would offer their own plan or automatically sign up workers for a state-run plan. Congress has voted to roll back a regulation that would ease the way for states to offer such plans; states still plan to proceed.
Some, including Brown University’s Friedman, advocate a portable, national retirement savings account that workers could take with them from job to job, ensuring that there’s no letup in saving—or worse, a cash-out—after a job switch. The plans would be funded via payroll deductions and administered by financial-services firms.
Even if Washington does nothing directly to alter the 401(k), the changes to the tax code that may be coming could affect how people save. Most 401(k)s provide the tax break upfront—no tax is owed until the money is withdrawn—but many companies offer Roth 401(k)s, which allow savers to pay taxes now and avoid them in the future. Should tax rates fall, Roths could become an even more attractive option for some, says Brigitte Madrian, a professor at the Harvard Kennedy School. First, the taxes paid now will be smaller. And if tax cuts aren’t matched by spending cuts and lead to bigger deficits, there’s a good chance future tax rates will be higher, making a pile of tax-free money more valuable. For those able to build one.
The bottom line: For many, the barrier to saving for retirement isn’t taxes, but lack of access to a plan that’s easy to set up and use.