December 5, 2022
Federal Policy Director
December 5, 2022
The EARN Act and SECURE Act 2.0, two bipartisan retirement bills working their way through Congress, are major disappointments. They would mainly provide more tax breaks for the well-off who will most likely retire comfortably regardless of what policies Congress enacts. Already the top 40 percent of taxpayers receive 87 percent of the tax benefits for retirement savings.
The bills would provide modest assistance for those who really need help to save. The EARN Act would provide 50 percent matching payments for contributions individuals with modest income make towards their retirement savings (with the matching payments capped at $1,000). This is an improvement over the existing Saver’s Credit, which is non-refundable, meaning it does not help someone who earns too little to have any income tax liability.
But this provision would provide approximately $2 billion of benefits a year, whereas one of the EARN Act’s poorly targeted provisions described below (allowing well-off people to hold savings in tax-sheltered accounts longer) would alone cost more than $4 billion a year. Both bills would direct far more resources to families most able to fund their retirements.
The Failure of Tax Breaks for Retirement Savings
Nobel prize winning economist William Sharpe said retirement planning is the nastiest, hardest financial problem to solve. None of us knows how long we will live and how much income we will really need in retirement. This uncertainty led Congress to create and expand the Social Security program, which provides several types of benefits but is best known for its retirement benefits. There are proposals in Congress today to further expand Social Security as well as Supplemental Security Income (SSI), the program for very low-income seniors and people with disabilities.
But since the 1980s lawmakers have increasingly focused on expensive tax cuts to encourage individuals to secure their own retirements. The individual-based system has failed most workers, especially those with low incomes and little wealth who cannot take advantage of the tax breaks.
In a way, solving the problem of retirement financial insecurity is not controversial or complicated. People need to earn more during their working years. Tax breaks that ostensibly encourage saving for retirement really reward those who would save no matter what because they have comfortable incomes.
The Congressional Budget Office confirmed this a year ago when it estimated that in 2019 the richest 20 percent of Americans received 63 percent of the tax breaks for pensions and retirement savings accounts. The poorest 20 percent of Americans received less than 1 percent of the benefits.
Even analysts who might not agree on solutions can agree on the underlying problems with current tax provisions. As the Bipartisan Policy Center recently explained:
A BPC-Morning Consult poll found that only 52% of individuals with household income at or below $50,000 have access to an employer-sponsored retirement plan, compared to 79% of people with higher household income. Moreover, small businesses, which employ 47% of American workers, often report that the financial and administrative obligations associated with setting up a retirement plan for their workers deter them from doing so.
The Enhancing American Retirement Now (EARN) Act passed out of the Senate Finance Committee over the summer and the Securing a Strong Retirement Act of 2022 (SECURE Act 2.0) passed by the House of Representatives earlier this year are both bipartisan bills, very similar to each other, that would mostly continue this failed tradition of individual incentives and voluntary savings.
How Existing Tax Breaks for Retirement Saving Work
The patchwork of tax breaks created by Congress to encourage retirement saving is complicated but rests on a few basic assumptions. People typically pay taxes on their income. People are typically not allowed to defer income taxes until future years, which would effectively allow them to avoid taxes. A tax liability to be paid in the future is worth less than a tax liability of the same amount due today because of inflation and discounting. (If you owe $100 in taxes but you can wait ten years before you pay it, you have effectively avoided tax because $100 will be worth less in a decade than it is worth now and you could have invested it and generated more income.)
However, Congress makes exceptions and allows tax deferrals or other types of tax breaks to encourage people to do certain things that serve a public purpose. At least that’s how these exceptions are always presented. Whereas normally we pay payroll taxes and income taxes on the compensation we earn, Congress provides exceptions for compensation we save for retirement, often allowing us to defer paying income tax on a certain portion of the compensation we save in 401(k) plans or Individual Retirement Accounts (IRAs) until we withdraw the money in retirement.
For those with enough income to save, this provides significant advantages. If the usual income tax rules applied, all compensation would be taxed as income when it is earned, leaving less to place in retirement accounts, and any income generated by investments in the retirement account would also be taxed each year, as happens with a normal savings account. The tax breaks that delay income taxes until retirement often result in much larger savings to draw down later in life.
A Roth IRA achieves something similar but through a different route. Taxpayers are not allowed to defer income tax on the income they place in a Roth IRA (meaning contributions are not tax-deductible like contributions to traditional IRAs) but the income distributed from a Roth IRA during retirement is tax-free. Whereas most tax breaks for retirement savings allow a deduction on the money flowing into the account and taxes the income coming out during retirement, the Roth IRA does the reverse. The details are complicated, but in theory the savings for the taxpayer can be about the same.
The rules become complicated because tax breaks for retirement must include limits to prevent them from being tools for general tax avoidance. The EARN Act and Secure Act 2.0 would make these limits more lenient, in ways that will benefit those with more income and wealth.
How the EARN Act and SECURE Act 2.0 Would Change Retirement Tax Breaks
What Tax-Favored Retirement Savings Can Be Used For
For 401(k) savings and traditional IRAs, taxpayers face a ten percent penalty if they withdraw money from their accounts before age 59 ½. After all, the point of these tax breaks is to encourage retirement, not simply reduce taxes. But lawmakers also felt compelled to allow early withdrawals without penalty in certain sympathetic situations that naturally must be defined carefully, resulting in a series of rules that no one can remember without consulting the internet or a financial adviser. (For example, up to $10,000 can be withdrawn penalty-free to buy a home if they are taken from an IRA, but not a 401(k) plan.) However, every withdrawal reduces retirement security.
The EARN and SECURE 2.0 Acts would create additional exceptions intended to address specific problems but this also would add more complexity. Both bills would allow victims of domestic abuse to make an early withdrawal, without penalty, of up to $10,000 (or half the account balance, whichever is less) from their IRA or 401(k). (Income tax would be due on the income withdrawn but would be refunded if the funds are repaid into the account within three years.)
Policymakers feel rightfully compelled to address domestic violence, but requiring victims to withdraw half of their retirement accounts to escape abuse could clearly lead to future problems for the very people this policy is supposed to help. Of course, many suffering from domestic abuse have not been able to save for retirement and would not benefit in any way.
Required Minimum Withdrawals
While penalties are aimed to discourage taxpayers from taking withdrawals too early, another rule is needed to prevent them from keeping money in tax-favored retirement savings for too long. Under the current rules, minimum distributions from 401(k) plans and traditional IRAs must be taken by age 72. Without such a rule, wealthy people would continue to use these tax-favored accounts not to prepare for retirement but to simply to avoid taxes and leave money to their heirs. That might be nice for the heirs, but again, these tax breaks are aimed to help people save for retirement, not pass wealth on to their heirs.
The EARN Act and SECURE Act 2.0 would raise the age when minimum distributions are required from 72 to 75. Most people who have not yet tapped into their retirement savings by age 72 have other sources of income and are probably quite well-off. The most likely effect of this change is to allow such people to defer more income tax and leave larger estates to their heirs.
Annual Contribution Limits
To prevent tax-favored retirement savings accounts from becoming unlimited tax shelters for people who already have plenty of wealth, the law restricts how much an individual can contribute to them each year.
In 2022, under current law individuals cannot contribute more than $6,000 to their IRA or Roth IRA, except that individuals age 50 or older can make an additional “catch-up” contribution of $1,000. Those with an employer-sponsored, 401(k)-type plan cannot contribute more than $20,500 in 2022, except that individuals age 50 or older can make an additional catch-up contribution of $6,500.
For employer-sponsored plans, both bills would increase the catch-up contribution limit for people in their early 60s from $6,500 to $10,000. But, as the Center on Budget and Policy Priorities points out, “only around 15 percent of retirement account holders approach the current limits, according to a Vanguard survey of its account holders, so this provision would overwhelmingly benefit people high on the income scale who can afford to contribute more.”
The Need for Limits and Rules on Retirement Tax Breaks
Someone who has not studied the intricacies of retirement tax policy might wonder whether it must be so complicated. After all, one might think, if I have saved money, why does Congress get to tell me when and how I can spend that money without penalties?
The answer, of course, is that all the rules and complicated limits are necessary because these retirement accounts are tax-favored, meaning they come with huge tax breaks that would otherwise blow up into all-purpose tax avoidance vehicles, unraveling the income tax as we know it.
Actually, this is already starting to happen, and we probably need even more complicated rules to stop it if we continue to use the tax code to encourage people to save for retirement. For example, despite the strict limits on contributions to a Roth IRA, the tech mogul Peter Thiel has a Roth IRA worth $5 billion. Theil placed business assets in his Roth IRA several years ago, apparently claiming they were worth no more than the contribution limits. Now those assets are worth $5 billion, meaning he generated $5 billion of income on which he will never pay income taxes. (Remember, contributions to a Roth IRA are not deductible but income coming out of a Roth IRA is tax-free.)
How did Thiel pull this off? It’s a long story (read ITEP’s take here) but the solution is clearly for Congress to enact better rules and allow the IRS to enforce them. That would be a far more productive way for Congress to improve existing retirement tax breaks than the EARN Act or SECURE Act 2.0.
True Cost of The New Retirement Tax Breaks Would Be About $100 Billion Over a Decade
Lawmakers probably think they can wave away these concerns by claiming that these tax breaks will not cost anything. The official revenue estimate of the EARN Act shows that its revenue-raising provisions offset its tax-cutting provisions so that the bill has a net cost of essentially nothing over ten years. But that seemingly benign estimate is the result of gross manipulation of the timing of tax payments. Most of the revenue-raising provisions just shift individuals from traditional IRAs to Roth IRAs.
Recall that with traditional IRAs, income is tax-free when it goes into an account but is taxed when it comes out during retirement, whereas Roth IRAs do the reverse. After-tax income flows into a Roth IRA but it is tax-free when it comes out during retirement. The two approaches can yield the same savings for the taxpayer, but with Roth IRAs the government technically receives tax revenue earlier rather than later. This means the bill’s provisions to shift people from traditional IRAs to Roth IRAs merely shift the timing of tax payments. They raise revenue compared to current law for a few years in the ten-year budget window that Congress pays attention to, but then they will lose revenue compared to current law in later years, outside the ten-year budget window, with no real effect in the long-term. For Congress to use these provisions as “revenue-raisers” is a nonsensical gimmick.
There are other budget scoring gimmicks in the legislation as well. For example, one of the most costly provisions, the one changing the age for minimum distributions from 72 to 75, does not take effect until 2032. This means that only one year of the costs shows up in the ten-year budget window that Congress looks at. The Committee for a Responsible Federal Budget estimates that without these gimmicks, the EARN Act would cost around $84 billion over a decade. This $84 billion estimate (plus inflation) is more representative of what the bill will cost every ten years after 2032. But by that point, who will remember what this arcane discussion about minimum distributions, early withdrawals and contribution limits was all about? By then, Congress will have gotten away with it.
I would like to thank Teresa Ghilarducci, Director of the Schwartz Center for Economic Policy Analysis (SCEPA) at The New School, for her comments. Any errors are my own.