Brookings proposal starts debate on 401(k) tax deduction

A proposal to replace the current 401(k) tax deduction with a flat tax credit has opened the door for further congressional brainstorming on ways to boost retirement savings, despite a lukewarm response from senators and dim prospects for legislative change.

The proposal from the Washington-based Brookings Institution would end the current tax exemption for employer and employee contributions and replace it with a saver's credit, or matching government contribution, that goes directly into taxpayers' retirement savings accounts.

The proposal is just one of several that could be considered by the congressional supercommittee charged with trimming the federal deficit by $1.2 trillion or more, before Thanksgiving.

The federal budget implications of pension tax exemptions have come under scrutiny in recent days as members of the supercommittee cast about for ways to increase federal revenues in politically palatable ways. Despite the popularity of retirement savings incentives through employer-sponsored plans, “everything has to be on the table” when it comes to taming the federal deficit, a Senate aide said on condition of anonymity.

“For the amount our country spends on retirement savings, are we getting enough bang for our buck?” asked Sen. Max Baucus, D-Mont., chairman the Senate Finance Committee and a supercommittee member, at a Sept. 15 Senate Finance Committee hearing on the Brookings proposal. While recognizing the reality of the baby boom generation approaching retirement, he said, “we need to look for ways to do more with less.”

'Tuneup, not overhaul'

Mr. Baucus noted that combined tax incentives for pensions, individual retirement accounts and employee stock ownership plans cost more than those for health insurance and home mortgage interest. But given the strong support for the current tax exemptions for employer-based retirement savings, Mr. Baucus asked witnesses if the more practical question should be, “Do we need a tuneup, not an overhaul?”

William G. Gale, director of Brookings' retirement security project, told the Senate committee that eliminating current deductions for contributions and instead offering a 30% matching contribution would be revenue neutral over the next 10 years, while offering an 18% matching rate would increase federal tax revenue by $458 billion over the next decade. Critics of the proposal dispute the assumptions used in those projections, and argue that current tax breaks are deferrals, not lost tax revenue.

Mr. Gale said that a flat credit would also address what he called the “upside-down” tax advantages of the current incentives for 401(k) and IRA contributions, which he said benefited higher income people who already save more.

However, Jack VanDerhei, research director of the Washington-based Employee Benefit Research Institute, testified that the Brookings proposal would hurt lowest-income workers most. Based on new modeling results of 401(k) plan surveys, “the surprising result we found” was that lowest-income workers said they would reduce or stop contributing to work-based plans if the current exclusion ended, Mr. VanDerhei said.

The potential negative effect on retirement savings in the Brookings proposal and similar ones advocating lower tax-deductible contribution limits prompted plenty of criticism from groups representing employers and retirement plan sponsors, who warned that savings rates would plummet as employers were discouraged from offering plans and employees were left to make retirement savings decisions on their own.

Such proposals “are based on perpetual myths” about workers' access to plans, disproportionate advantages for wealthy taxpayers, and potential tax revenue increases if the exemptions were eliminated, Judy Miller of the American Society of Pension Professionals & Actuaries, Arlington, Va., noted at the Senate hearing.

“We are very concerned that the proposals under discussion would discourage small business owners from setting up or maintaining a workplace retirement plan,” said Ms. Miller, who is chief of actuarial issues and director of retirement policy at the ASPPA. “This is the exact opposite of what needs to be done.”

'A bad idea'

Larry Goldbrum, executive vice president and general counsel of The SPARK Institute, a coalition of retirement plan service providers based in Simsbury, Conn., agrees. “It is important to look for ways to increase more access (to retirement savings), but discarding the only successful retirement system we've had to try an academic experiment we think is a bad idea.”

That reality has pension lobbyists braced for more discussion, if not radical change. With the proposed saver's credit targeted at only low- and moderate-income workers and discouraging employers from offering retirement plans, for example, “I don't anticipate that the credit approach will be enacted in the near future,” Edward Ferrigno, vice president, Washington Affairs for the Profit Sharing / 401k Council of America said in an email.

Brookings' Mr. Gale, who is also working on an auto-IRA proposal, said that while the opposition seems determined to control the debate, “I hope it goes in the direction of thinking creatively about how to strengthen the retirement system while recognizing the problems.”