Retirement income, your IRA and 401(k), tax laws, discrimination and the Progressive view of fairness

My recent e-mail from the Center for American Progress (CAP) talks about the benefits of tax-free retirement savings and the cost in terms of lost revenue for the federal government. I find that concept intriguing. It is as if the government is entitled to everything, but it loses part of “everything” when it does not take it from the citizens. That seems a bit backward to me.

You can read their position on tax breaks for retirement savings here.

In essence their point is that the tax laws intended to encourage saving for retirement are not sufficiently progressive. This means that the people who pay most of the taxes and will likely be in the higher tax brackets in retirement will gain the greater tax advantage from the current laws and lower-income people who cannot save as much and who pay little, if any, income tax get much lower benefit from the tax laws. What a concept!

High-income individuals also have more disposable income to save. The greater a person’s income, the more likely he is to contribute to a 401(k) or IRA.  Though there are limits on the amount of tax-deductible and overall contributions individuals can make to tax-favored savings vehicles, those limits are high. The combined annual limit on employee and employer contributions to a 401(k) plan is $49,000 in 2011.

The tax system steers retirement subsidies toward high-income individuals in another way. Workers in higher tax brackets receive more savings than workers in low tax brackets because the tax incentives are structured as deductions. Last week’s installment of this series illustrated that a similar “upside-down” effect occurs with the tax break for employer-sponsored health insurance.

How can there not be an unequal distribution of tax breaks when there is an unequal distribution of taxes paid? Given that nearly 50% of Americans pay no income tax, why would they want to use any form of tax advantaged retirement savings?   However, CAP does not stop with taking the tax advantage from the “wealthy,” instead it wants to give an extra measure to lower-income.

“The retirement tax incentives can be restructured so that they encourage savings in a more progressive way, with more broadly shared benefits. One way to do that is to provide tax credits for retirement savings instead of deductions. Tax credits provide dollar-for-dollar reductions in the amount of taxes a person owes regardless of the tax bracket they fall in. So a middle-income person who owes $5,000 in income tax a year and a wealthy person who owes $50,000 would both benefit equally from a $1,000 tax credit.  The middle-income person would see his tax bill go down to $4,000, and the wealthy person’s down to $49,000.  [Ah, benefit equally you say? My fifth grade math tells me that one person is seeing a 20% reduction in taxes and the other a 2% reduction].

There is a so-called “saver’s” tax credit, but it is modest and could be designed better to reach more people.  National Economic Council Chairman and former CAP Senior Fellow Gene Sperling has proposed a progressive framework for retirement security. One of his ideas is to create a universal 401(k) plan, available to all workers, and replace the current tax deductibility component with a flat tax credit of 30 percent for all worker savings. That plan would distribute the retirement-savings incentives more fairly and target the people most likely to reach retirement without enough money to live on.  [What am I missing here? Won’t the wealthy still be able to save more and thus benefit more from the tax credit?]

Recently, the Bipartisan Policy Center proposed a similar reform: a 12 percent “refundable” tax credit for retirement savings available also to those who do not owe federal income taxes at the end of the year.” [There you go, a new welfare program for retirement, 12 percent of your income.]

The article also notes that contributions to an IRA or 401(k) plan are not subject to income tax. Clearly what they really mean and later note is that the contributions are tax deferred. What they do not make clear is that early withdrawals are subject to a 10% tax penalty and withdrawals, including earnings on contributions, are taxed as ordinary income and not taxed as capital gains, as are non-deferred investments. The capital gains tax rate would be much lower. Actually, higher income people are paying more by deferring these gains. In addition, because of the limits on contributions to both IRAs and 401(k) plans a disproportionate percentage of total income can be deferred by lower-income individuals.

Consider these facts not mentioned by the Center for American Progress.  The $49,000 limit on contributions has not changed in three years.  Under IRS rules there is an overall limit of $245,000 (also not changed in three years) on eligible compensation.  Not chump change to be sure, but hardly in the million dollar income stratosphere.  So what does this mean, it means that regardless of how much you make the percentage contribution to your 401(k) cannot be based on more that $245,000 in pay.  So, even if you do earn the top amount, in a typical plan you would have to contribute 17% of your pay (assuming your employers adds 3%) to reach the maximum.  If you earned $100,000, in order to reach the maximum contribution you must contribute 46% of your pay (an amount not even permitted in most plans).  In addition, there are discrimination tests preventing highly compensated people from disproportionately benefiting from these plans.  Finally, the most highly compensated people often do not use the 401(k) plan or contribute only to the level necessary to receive the company match, typically 7 to 8% of pay. 

I do agree on some points. The tax laws are too complicated, we have too many tax advantaged “retirement” plans and they are underutilized at all levels of income. Every individual should have the opportunity to save tax-advantaged to a set percentage of his income up to an affordable (for the government) maximum. The tax benefits accrue in proportion to ones tax liability and the maximum assures the benefit is not skewed to the wealthy.

Let’s look a the broader picture of retirement income and include Social Security. Using the benefit estimator a person earning $50,000 who retires at the full benefit age in February 2011 receives a benefit for himself and a spouse of $23,595 a year or 47.184% of his last years earnings. On the other hand, a person in the same situation earning $100,000 receives a total benefit of $36,288 or 36.288% of his earnings. In addition, the person earning $100,000 paid twice as much in Social Security taxes as the middle-income person. Now there is real progression for you.

There are other tax benefits skewed to lower-income workers as well. For example, file a joint return, and you and your spouse have a combined income that is between $32,000 and $44,000, you may have to pay income tax on up to 50 percent of your Social Security benefits; more than $44,000, up to 85 percent of your benefits may be taxable.

In addition, tax laws limit the pension benefit that can come from a qualified (tax advantaged) trust. Under the Pension Benefit Guarantee Corporation only limited benefits are insured thus favoring the lower paid lucky enough to have a defined benefit pension. Under PPACA there will be no limit on the income subject to the Medicare tax. Individuals who receive a portion of their pension from outside of a qualified trust must pay Social Security and Medicare taxes, in advance, on the present value of the benefit they receive even if they don’t live to collect the pension benefit.

The point is, you cannot isolate one section of the equation and claim a lack of fairness. Scores of laws limit the benefits and increase the taxes paid by higher income Americans.

There are high, middle and low-income human beings and their entire economic situation is proportional to their income. Unless you believe that no American should have an income greater than the national average of $50,000 +-, income levels will always vary and that includes income in retirement.

Who isn’t for fairness? However, the idea that to be fair to one group of people you must be less fair to another is disturbing as is the concept that government is the judge in all these matters or that government has the responsibility to allocate each individual’s resources for personal matters such a retirement. I guess that is why I am right-handed.

The real concern is assuring that the folks on the lower economic rungs of society have an unhampered ability to rise to any level they are able to achieve.  The progressives in America who see success as being unfair should focus their attention on the decisions, life choices and behavior that keep many Americans from improving their lot in life. Instead of spending $2 billion on the next presidential campaign, put half of it into job training.


  1. I like “Instead of spending $2 billion on the next presidential campaign, put half of it into job training.”

    But I don’t see why it should cost $1 billion to train the next president! 😉

    Great post!


  2. Most liberal analysts esp those working in the federal govt, miss the big picture on almost every issue. Higher paid folks get screwed by the SS pension calc. If they make $100k now and retire at SSNRA with 35 yrs work history they get 90% of first 9k pay, 32% of next 46k pay and 15% of last 45k pay — grand total of $29k SS pension — 29% ‘replacement ratio’. A $20k worker gets 90% of 9k pay and 32% of next 11k pay — $12k pension which is 60% ‘replacement ratio’. So the higher-income person got shafted. Why in the world would it NOT be fair as our current 401(k) rules say, that the higher-paid should not be able to save say $10k or $20k and save 28% of federal tax on that amount? That taxpayer is already getting royally screwed, so at least should be able to save a couple federal tax dollars. He certainly needs it and deserves it. The federal govt has proven it doesn’t deserve 1/2 of what it takes now. It has messed up almost everything it’s tried to ‘fix’.


  3. Most articles by so-called progressives discuss tax advantages and savings advantages of the wealthy and leave out the last point — how the wealthy got where they are. They presume that someone ‘handed it to them’. To be sure, there is some of that, but inheritance taxes mitigate the effect. By far most of the people I know who earn six figure incomes worked hard long hours to get a college education followed by long hard hours working for a living.
    For some reason, progressives don’t believe that hard work should have its rewards. hmmmm….


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