The unpopular case for capping the 401(k) contribution

So are we capping these 401(k)s or what?
So are we capping these 401(k)s or what?
Image: AP Photo/Evan Vucci
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As Republicans in Congress prepare to cut taxes dramatically, they are looking for ways to cover the cost. One idea has dominated the public discussion: Capping the amount of money Americans can contribute to tax-deferred 401(k) savings accounts.

Republican members of Congress have contemplated this policy as a way to pay for some of their cuts, and US president Donald Trump has variously proclaimed that “it stays!” or that he will negotiate regarding the caps.

Retirement savings are major problem in the US both economically—because so few Americans are saving enough for their futures—and politically—because the people who do take advantage of saving incentives boast higher incomes and commensurately louder political voices.

Consider what happened when the Obama White House proposed capping a similar plan that allowed Americans to save money for their children’s educations. The administration’s argument was simple: The vast majority of gains in tax-free college savings accounts known as 529 plans accrued to Americans who earn more than $200,000—the top fifth of American earners. It would better, the theory went, to reduce the tax break and use the savings to expand tuition tax credits that disproportionately benefit poorer Americans.

The idea to cap the plans was dead on arrival. In an America increasingly polarized by income inequality, the idea of cutting benefits to the top 20% of households to benefit the other 80% is controversial in both parties. Indeed, few people consider themselves wealthy even when they bring in far more than the median US household income of $59,000. And, as financial journalist Josh Barro pointed out when the 529 cap was proposed, many of the people driving the discourse over these policies—reporters, academics, political operatives, and researchers living in expensive metros—find themselves in households that benefit from them.

The same dynamics are at play today with the 401(k). The 401(k) plan disproportionately benefits the highest-earning Americans because they have the most money to save. A 2013 analysis by the Congressional Budget Office found that two-thirds of the tax benefits went to the top 20% of earners. Boston College’s Center for Retirement Research crunched the numbers from 2016 to come up with the following distribution of retirement savings and 401(k) participation among working-age Americans.

As you can see, 401(k) participation comes from high-earning Americans. The numbers become more frightening when you break it up by age bracket and income level. Research from the National Institute on Retirement Security shows that among working-class households—those with incomes below $68,212—half of Millennials and Gen-Xers have no retirement savings at all. The median savings for working class Baby Boomers rises—to just $1.

This is why some economic thinkers say capping 401(k) contributions might be a good idea—because uncapped, they mainly seem to help the rich get richer. Recent Nobel laureate in economics Richard Thaler tweeted an “unpopular observation” this week: “reducing the limit on 401k contributions is massively progressive.” The proposed Republican tax plan already disproportionately benefits the wealthy and high earners; taking away a break that largely benefits them would help offset that—in theory.

“Lowering the cap does increase the progressivity of the system, but there’s a point at which that stops being true. It depends on what you do with the rest of the money,” says Justin King, a policy analyst at the New America Foundation.

At the moment, Republican lawmakers are nervous about plans to limit the deductibility of state and local taxes—which would mean people living in high-tax states like New York, California, and Illinois pay more. They don’t want to deal with another controversy. Besides voters, the 401(k) is also beloved by the puissant financial services industry because it increases the amount of money they get to manage and collect fees on.

Progressive politicians are caught in a bind here. Leveraging anger about the end of popular tax breaks is likely the only way Democrats can kill a tax cut they hate—but at least some would like to kill the same popular tax benefits should they return to power in the future.

By the end of the year, the 401(k) could be capped to help generate a regressive tax cut—or the mere idea of capping it could help kill the bill, further reinforcing the apparent political impossibility of raising taxes on the wealthy.

King worries that using proposals to cap 401(k) contributions to fight the current tax —”if people who might be progressive champions of a better system are going to run to the barricades with the [financial services] industry and everybody else”—could make future efforts at progressive reform more difficult.

Diane Oakley, who leads the National Institute on Retirement Security, says the proposal “sends the wrong signal when what we really need to do is encourage more people to save. And that’s the problem with a cap like this: Washington doesn’t think you need the tax incentive” when the savings rate for lower-income brackets suggests people do. She says the best approach would be increasing savings incentives for the poor, not decreasing them for the rich. “We ought to be beefing up the savers’ credit more like a match that would target the tax resources to the people who need the most amount of help.”

The savers credit itself was originally designed to make the 2001 Bush tax cuts more progressive. King and Oakley say it would boost the financial security of low-income Americans to expand the credit to be more generous, and barring that, to at least promote broader usage of the existing benefit. But one clue that the mooted 401(k) caps are more about making tax-cut math work than leveling the playing field is that the Trump administration has made it harder for working class people to access automatic, tax-deferred retirement accounts.

“Limiting the amount you can defer tax to save for retirement is really shortsighted,” Oakley says. “If we have more and more people reaching retirement who don’t have the resources, that’s going to put a lot more pressure for Social Security…in addition to that, we’re going to have pressure on things like Medicaid and Medicare and food stamps, just from basic expenses for older Americans. The largest increase in food stamps during the Great Recession was at the older ages.”