Tax Reform Initiatives Fail to Protect Retirement Savings

A recent report by the Employee Benefit Research Institute explored the possible consequences of modifying the federal tax treatment of 401(k) plan contributions. 

The EBRI report, written by Jack VanDerhei, looked at Obama’s proposal on federal debt reduction, “The Moment of Truth,” which was issued in December 2010. The document proposed modifying private-sector retirement plans by capping annual “tax-preferred contributions to the lower of $20,000 or 20 percent of income,” sometimes called the 20/20 cap.

He also looked at a plan proposed by William Gale, co-director of the Urban-Brookings Tax Policy Center and director of the Retirement Security Project at The Brookings Institution, that would modify the existing tax treatment of both worker and employer 401(k) contributions and introduce a flat-rate refundable credit that would serve as a federal matching contribution into a retirement savings account.

Previous reports on the subject talked about the negative effect these proposals would have on individual retirement savings, but did not look at how the changes would affect plan sponsors or plan participants’ ability to accumulate retirement savings, VanDerhei said in the report.

Surveys of plan participants and plan sponsors have shown that some would change or reduce their contributions if tax incentives for 401(k) plans were changed.

“Recent surveys of plan sponsors also suggest that not only would some matching contributions be changed in response, but that some employers would cease offering these retirement plans altogether,” the report stated. “Smaller employers were more likely to respond negatively to the proposed changes than larger employers.”

EBRI baseline analysis indicated that plan-sponsor modifications, combined with individual participant reactions, would result in an average percentage reduction in 401(k) balances of between 6 percent and 22 percent at Social Security normal retirement age for workers currently ages 26 to 35.

Plan size had a lot to do with the severity of the response.  401(k) plans with less than $10 million in assets would experience average reductions in participant balances at retirement age of between 23 and 40 percent for workers currently ages 26 to 35, the report found.

EBRI’s report took into account findings from a 2011 report by The Principal Financial Group that determined that if workers’ ability to deduct any amount of the 401(k) contribution from taxable income was eliminated, 65 percent of the plan sponsors responding to the survey would have less desire to continue offering their 401(k) plans. The EBRI report also used data from a 2010 AllianceBernstein report that questioned plan sponsors about how they would respond if employees could no longer deduct retirement savings plan contributions from their federal taxable income and had to pay federal income tax on anything an employer contributed to their savings plans. In exchange, they would receive an 18 percent match from the U.S. government.