A recent tax reform proposal may bring the end to the cherished tax shelter of a retirement plan deduction. During testimony to the U.S. Senate Committee on Finance last September, William Gale discussed a proposal to eliminate the current tax deduction on retirement savings plans and suggested replacing it with a flat-rate refundable credit that would be deposited directly into the saver’s account. Gale, who is the Director of the Retirement Security Project at the Brookings Institution, wants to see a new incentive structure for contributions to retirement savings accounts by changing the treatment of retirement savings in three ways:
- First, unlike the current system, workers’ and firms’ contributions to employer-based 401(k) accounts would no longer be excluded from income subject to taxation, contributions to IRAs would no longer be tax-deductible, and any employer contributions to a 401(k) plan would be treated as taxable income to the employee (just as current wages are).
- Second, all qualified employer and employee contributions would be eligible for a flat-rate refundable tax credit, given to the employee.
- Third, the credit would be deposited directly into the retirement saving account as opposed to the current deduction, which simply results in a lower tax payment than otherwise.
One area that is not clearly addressed as part of this reform is whether higher income earners will be phased out from the credit, similar to many credits now that are reduced or eliminated based on certain income thresholds. Here are some examples of tax credits that phase out based on income thresholds:
Child Tax Credit – the $1,000 credit for dependents under age 17 begins to phase out at $110,000 for MFJ filers and is totally phased out at $149,001 for a family with 2 qualifying children
Lifetime Learning Credit – this education credit begins to phase out at $102,000 and is totally phased out at $122,000 for MFJ filers
Adoption Credit – qualifying adoption expenses of up to $13,360 is phased out for taxpayers making over $225,210
The irony about this proposed move to a tax credit instead of a tax deduction on retirement plans is the fact that we already have a Retirement Saver’s Credit that offers low income workers up to a 50% tax credit on the first $2,000 of retirement plan contributions to either an IRA or an employer-sponsored retirement plan. Unfortunately, the majority of workers most likely to qualify for this Saver’s Credit are not taking advantage of saving for their retirement, even with the tax credit as an incentive. According to EBRI’s 2012 Retirement Confidence Survey, only 35% of workers with income under $35,000 reported that they are saving money for retirement. Currently, these lower income workers can benefit from both the tax deductibility of their contributions from their taxable income and the Saver’s Credit. The proposed tax credit under Gale’s plan would only offer an 18% tax credit and would eliminate the tax deductibility. So the question remains how any potential increase could be expected to the participation rates for these lower income workers if the current tax breaks aren’t doing the job. Since the EBRI survey found that the large majority of workers who have not saved for retirement have little in savings (almost two-thirds reported they have less than $1,000 in savings and investments), perhaps the better solution to encouraging these lower income workers is to provide education on basic money management.
Next week I will focus on another proposal called the 20/20, which leaves deductions in place but caps the overall limits to retirement plan contributions.