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The Case for Revamping 401(k)s

Benjamin Harris

Over the next five years, the federal government will provide subsidies in excess of $1 trillion for retirement saving, according to estimates from the Joint Committee on Taxation. The bulk of these subsidies will be delivered through defined-contribution accounts, such as 401(k)s and IRAs, that lower savers’ tax bills if they sock money away for retirement.

While retirement security is indeed an important policy goal, the way we subsidize such saving is ineffective, regressive and in pressing need of reform. Here’s why.

When someone puts money in a 401(k) or traditional IRA, the value of their tax savings is based largely on their tax rates during both their working years and retirement. Under this system, people deduct from taxes contributions made to a retirement account. This contribution is invested and grows tax-free until retirement, when retirees pay taxes on withdrawals from these accounts. This “deferral” of taxes on investment returns confers significant benefits. Account holders receive a double benefit if their tax rate in retirement is lower than during their working years.

This system is flawed for several reasons. One, it’s regressive and worth little-to-nothing to people with low income. In a given year, more than 40% of taxpayers won’t pay income taxes (although they will pay other taxes, such as payroll taxes, sales taxes and property taxes), according to the Tax Policy Center. If you don’t pay income taxes, you won’t benefit from an income-tax deduction.

Not only does that undermine their retirement, it can impact their ability to weather hardship during their working years, too. In the midst of the 2007-09 recession, crowds of workers borrowed from their retirement accounts to help cushion the blow of a once-in-a-generation downturn. But households can only draw on retirement plans if they have savings in the first place. 

The system is also exceptionally complex; understanding your tax break from saving requires knowing your current tax rate, investment earnings and how you’ll take withdrawals in old age. Over decades of studying retirement, the only places I’ve ever seen this tax benefit explicitly calculated is in the appendices of academic papers. That isn’t very helpful for the typical saver.

The biggest problem with this flawed system, though, is that the tax subsidies are often ineffective. While they boost saving within retirement accounts, some studies have found that every $1 in tax-based incentives boosts total retirement saving by just pennies. In other words, savers just shift savings from nonretirement accounts into 401(k)s and IRAs instead of saving more. This is due to a host of factors: Some people don’t pay attention to incentives, subsidies mean that workers can save less and still reach a given wealth target, and the tax breaks are worth little to those in lower tax brackets. All told, the research suggests a terribly inefficient system.

So what is the alternative? A better way is to direct billions in subsidies through a direct match on worker contributions.

Rather than making the subsidy dependent on tax rates, savers should get a transparent upfront credit for putting money into a retirement account—say 25% of contributions. Workers who put in $100 would get an extra $25 deposited in their account—regardless of whether they are earning $50,000 or $250,000. The benefit should be capped to avoid the subsidy from growing out of control. That is, just as current savers can’t get a tax break for contributions over $18,500 to 401(k)s, the same cap would apply under the new system. To encourage workers to actually save their tax credit, this new system would deposit the credit directly into the retirement account—rather than refunding it back through lower income taxes.

The U.S. already has a pilot program of sorts through the current Saver’s Credit, which provides a limited number of taxpayers with a small plus-up on their retirement savings. But the benefit is complex, available only to a few and poorly advertised. By reforming the system of tax subsidies for saving to incorporate the spirit of the Saver’s Credit—more equal benefits for saving—Congress can help boost the value of retirement saving for millions of middle-class families.

This reform isn’t without shortcomings. Swapping a deduction with a flat-rate credit will lower the saving benefit for select high-income taxpayers, who may reduce contributions to retirement accounts. That could lead to a small number of employers dropping their plans altogether. And it only mitigates, but doesn’t fix, the complexity and regressivity inherent in the current system. Still, it’s an unambiguous improvement.

Retirement security should be a first-order priority for the American public. Let’s start by instituting a retirement saving system that does what it’s designed to do.

Dr. Harris is a visiting associate professor at the Kellogg School of Management and was the chief economist to Vice President Joe Biden. Email him at reports@wsj.com

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