Who Gets Paid to Save?

Who gains, and by how much, from government saving incentives? This question is tough to answer because the tax code has myriad interacting provisions, many of which are difficult to appreciate fully. Take, for example, workers who contribute to 401(k) plans. They lower their current taxes, but they also raise their future taxes. How much their taxes decline when the workers are young and rise when they are old depends on their tax brackets when they are young and old. But these brackets can change dramatically in response to the size of 401(k) contributions and withdrawals. Changes in tax brackets will, in turn, change the tax savings from mortgage interest payments and other tax deductions. In addition, the level of withdrawals can trigger higher federal income taxation of social security benefits and the phaseout of itemized deductions under the federal income tax. Clearly, measuring the net gains from tax-favored saving requires a model of lifetime saving, spending, and tax payments. It also requires detailed federal income, state income, and payroll tax calculators, because all three taxes are potentially altered by contributions to tax-favored accounts. Economic Security Planner (ESPlanner™), developed by Economic Security Planning, Inc., is a life-cycle financial planning model with highly detailed tax and social security benefit calculators that can assess the lifetime tax and spending implications of different types and levels of tax-favored saving.
We used ESPlanner™ (Gokhale and Kotlikoff, 2001) to study the size and pattern of tax breaks to saving. Our analysis, based on tax law prior to 2001, reached the remarkable conclusion that participating fully in 401(k) or similar tax-deferred saving plans raises the lifetime tax payments of low-income households who earn moderate to high rates of return! This finding is driven in large part by increased federal income taxation of social security benefits when 401(k) assets are withdrawn. Our study was written, however, prior to the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). EGTRRA greatly expands the limits on contributions to tax-deferred accounts, including 401(k), 403b, Keogh, and traditional IRA plans. It also raises the limit on contributions to non-tax-deductible Roth IRAs. Most important for the issue of tax fairness, however, it provides a significant but little known nonrefundable tax credit for qualified account contributions up to $2,000 made by low-earning workers.
This paper reviews the pre-EGTRRA lifetime tax gains (or losses) available to low-, middle-, and high-lifetime earners from participating fully in 401(k) accounts, traditional IRA accounts, and Roth IRA accounts. It then shows how these subsidies have been changed by the new legislation. The paper's bottom line is that EGTRRA mitigates, but doesn't fully eliminate, the lifetime tax increases facing many low-income households from making significant contributions to tax-deferred retirement accounts. Additional research is needed to understand how many low- and moderate-income households are paying higher taxes, at the margin, due to their saving through such accounts. Our sense is that most low- and moderate-income households are contributing less than the maximum possible amount to these accounts and are, thereby, limiting their losses. But even these households are being ill served because they have been told by the government, their employers, and their financial advisers that saving in tax-deferred accounts will deliver major tax savings.