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BAD MATH

Attacks against 401(k)s are missing the point

Allison Schrager
By Allison Schrager

Contributor

Odds are you aren’t saving enough for retirement—even though the US government keeps giving you reasons to do so. The most obvious are the tax incentives linked to 401(k) and similar retirement accounts. But some are questioning if those benefits are worth the cost.

It’s a pretty simple system: You put part of your salary into an investment account before paying tax, can’t access that money (unless you pay a penalty) until you turn 59.5, and then pay tax when you take the money out.

But the tax deferral isn’t cheap for the government, which is why it becomes a target when people start talking about the federal budget. The Joint Committee on Taxation estimates employer-sponsored defined contribution plans will cost the government $399 billion in forgone revenue between 2014 and 2018.

And for what benefit? Research from Denmark suggests tax incentives don’t increase savings. Automatically enrolling people into saving accounts—whether the money has been taxed or not—and selecting a saving rate for them is much more effective and needn’t cost the government anything.

These tax incentives also come under fire because they are arguably more beneficial to high earners, who are more eager to lower their tax bill and are more likely to have access to a retirement account.

No wonder some have suggested the US eliminate special tax treatment for these accounts. Chancellor of the Exchequer George Osborne thinks the UK should do so. He’d prefer Britons make post-tax contributions and get tax-free withdrawals—sort of like a Roth account in America. The Financial Times Chris Giles agrees, arguing that tax deferred pensions are opaque and offer little value. But these arguments are short-sighted; the value of the tax deferral is not just getting people to save more.

First of all, most estimates overstate the cost to tax-payers. 401(k)s are tax deferred not tax free. The $399 billion dollar amount is an estimate of how much taxes working people avoid by contributing minus how much retirees pay when they withdraw each year. The government is losing so much money because 401(k)s are still relatively new and people are only now starting to retire and withdraw from them.

It’s also worth noting that the tax deferred status of these retirement accounts come with risks for savers. In particular, savers are making a bet on what future tax rates will be when they make withdrawals.

Second, the taxes retirees pay on withdrawals are a powerful tool for policy makers to alter spending in retirement. Without facing a tax on withdrawals, someone might spend everything quickly and rely on government benefits. Others will spend too little and face a needlessly spare retirement.

Tax incentives can get people to behave better. Currently, Americans pay a tax penalty if they don’t take out a certain amount from their retirement accounts each year after turning 70.5. That amount, the Required Minimum Distribution (RMD), has a big influence on how much many Americans retirees spend.

This shows how much tax policy can nudge retirees toward spending. That’s better than forcing people into more extreme measures, tried in the UK, like requiring people to buy annuities or explicit limits on how much they can take out each year.

The argument for getting rid of tax deferrals is based on bad math and risks taking away a solid policy tool.

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