March 6, 2000

Pension Provisions of Tax Bill Coming to House Floor 
Would Heavily Benefit Highly Paid Executives and Business Owners 
But Could Jeopardize Pension Benefits for Ordinary Workers

by Peter R. Orszag, (1)

The tax bill Congress approved in August 1999 and the President subsequently vetoed included a number of tax provisions related to employer-sponsored pensions. These provisions, with only minor changes, are expected to be included in legislation to be considered by the House of Representatives the week of March 6 and then joined with minimum-wage legislation in conference. (The House is expected to take up tax legislation that the House Ways and Means Committee approved last fall when minimum-wage legislation seemed imminent, with one or a very small number of other tax provisions added to it. The pension provisions of this legislation are very similar to those of the vetoed tax bill.)

These pension tax provisions, which would cost $18 billion over 10 years (and nearly $3 billion a year by the tenth year), are ostensibly intended to expand pension coverage among working Americans. But although these pension provisions include several beneficial reforms, their principal impact would be to institute a major expansion of pension-related tax preferences for high-income individuals. Furthermore, some of the provisions are likely to lead to a reduction in pension coverage among low- and moderate-income workers and those employed by small businesses.

Two-thirds of the tax benefits of current pension tax preferences (including IRAs) accrue to individuals in the top fifth of the income scale. To promote retirement security and pension equity — and to boost national saving — pension policy reform should focus on expanding pensions for middle- and lower-income workers, groups with significantly lower rates of pension coverage than higher-income workers.

Effects of Proposed IRA, 401(k), and Other Pension Changes in Vetoed Tax Bill

Income Group

Income Range
(at 1999 levels)

% of Total 
Tax Cut

Lowest 20%

Less than

$13,300

0.0%

Second 20%

$13,300 –

23,800

0.2%

Middle 20%

23,800 –

38,200

0.4%

Fourth 20%

38,200 –

62,800

2.9%

Top 20%

62,800 or more

96.5%

All

 

100.0%

ADDENDUM

 

 

Bottom 60%

Less than $38,200

0.6%

Top 10%

$ 89,000 or more

91.5%

Top 5%

124,000 or more

86.6%

Note: Estimates include the effects of increasing the 401(k) annual contribution limit to $15,000, changing the 401(k) anti-discrimination rules, the over age 50 "catch up" rules for 401(k) contributions, and various other proposed pension changes.
Source: Institute on Taxation and Economic Policy Tax Model, October 18, 1999. Income in the ITEP model includes all cash income, including earned income, unearned income, and transfer payments. This definition of income is similar to that which CBO uses in its distributional analyses and that which Treasury uses when conducting distributional analyses based on cash income rather than family economic income.

The pension provisions under consideration, however, chart a different course. These provisions are skewed heavily toward those at the top end of the income distribution, the group that already receives the vast majority of the tax preferences for pensions, while doing little for workers in the middle and bottom parts of the wage scale. Analysis by the Institute on Taxation and Economic Policy of the principal provisions of the vetoed tax bill related to employer-provided pensions finds that:

The legislation would provide extremely generous new pension tax preferences to highly paid executives with salaries substantially in excess of $100,000. But it would likely result in little increase in pension coverage for lower-income workers. In fact, as discussed below, the incentives that some provisions of the legislation create could well induce a decline in pension coverage among low- and moderate-income workers and those employed by small businesses, exacerbating the problem of inadequate pension coverage among such employees.

As a result, these pension tax proposals represent a costly and inefficient approach to expanding pension coverage.

Pension Provisions Have Little to Do With Helping Small Businesses 
Absorb a Minimum Wage Increase

The pending tax legislation of which these pension provisions are a major part is promoted as helping small businesses cope with an increase in the minimum wage. In fact, the pension-related tax breaks in the bill have little or nothing to do with assisting small businesses in offsetting increased labor costs due to a higher minimum wage. The tax breaks primarily boost pension tax benefits for business owners and executives. Ironically, the one way these provisions would reduce labor costs is if employers used these provisions to reduce the pension contributions made on behalf of their low- and moderate-income employees.

Moreover, it appears that most small businesses do not offer pension plans. In 1993, only 13 percent of full-time workers in firms with fewer than 10 employees — and 25 percent of workers in firms with between 10 and 24 employees — enjoyed pension coverage. (By contrast, 73 percent of workers in firms with 1,000 or more employees have pension coverage.(2)a) It thus seems unlikely that many small businesses with significant minimum-wage workforces would be affected by these expansions in pension tax breaks for high-income individuals.


a U.S. Department of Labor, Social Security Administration, Small Business Administration, and Pension Benefit Guarantee Corporation, Pension and Health Benefits for American Workers, 1994.

Background

Along with Social Security and private savings, tax-favored pensions form an important leg of the "three-legged stool" of retirement income and security. One leg of the retirement stool is Social Security. A second leg is private savings, accumulated by families and individuals in a variety of forms (e.g., bank accounts and mutual funds). Pensions provide the third leg of the stool. Private and government pensions accounted for 18 percent of the total income of the elderly in 1996.(3)

Pension coverage is, however, very unevenly spread. Half of the American workforce lacks it. Pensions remain particularly scarce in specific segments of the labor market, especially among lower-income workers and employees in small businesses.

The lower rates of pension coverage among workers with lower incomes, combined with higher marginal tax rates for high-income workers and higher contribution rates among high-income workers with pension coverage, mean that existing tax preferences for pensions disproportionately benefit upper-income workers. Higher-income workers enjoy more access to pension coverage than lower-income workers do. Covered higher-income workers also make larger contributions to pensions than lower-income covered workers. Furthermore, because higher-income workers pay taxes at higher marginal tax rates, they receive a larger tax break for each dollar of contribution they make than their lower-earning colleagues do. These factors explain why two-thirds of the tax benefits of current tax preferences for pensions (including IRA tax preferences) accrue to those whose family incomes place them in the top fifth of the income scale.

 

Benefits of Progressivity in Pension Policy

Sound pension policy reform entails directing more of the pension-tax incentives to middle- and lower-income workers who currently are saving little, if anything, in pensions. Over the past five years, an important focus of pension reforms has been the expansion of pensions to workers with low coverage rates.

For example, the 1996 Small Business Job Protection Act included a variety of provisions to expand pension coverage among small businesses.(6) This emphasis on workers with low pension coverage is warranted for several reasons:

Since those with modest or low incomes are less likely to have other assets to shift into tax-preferred pensions, focusing pension tax preferences on moderate- and lower-income workers increases the likelihood that lost tax revenue will reflect additional contributions rather than shifts in assets. For example, assume the government announces a new tax incentive that allows individuals to exclude from taxable income up to $1,000 deposited in a retirement account. If a higher-income individual in the 31 percent marginal tax bracket takes $1,000 from an existing savings vehicle and moves it to the tax-preferred account, the government loses $310 in tax revenue that year without any corresponding new private saving (since the individual has merely shifted his or her assets from one account to another). On the other hand, if the tax incentive induces an individual in the 15 percent marginal tax bracket to save an additional $1,000, private saving increases by $1,000 while government revenue falls by only $150.

The smaller a worker's opportunity for shifting assets and the lower the worker's marginal tax bracket, the more likely it is that $1,000 deposited in such a worker's account will represent an increase in national saving. This example illustrates why focusing tax incentives on low- and moderate-income workers who do not have many other assets is more likely to raise national saving than tax incentives focused on higher-income workers. Focusing new pension tax preferences on low- and moderate-income workers would increase the likelihood that the new incentives actually would boost national saving.(8)

Pension reforms should therefore be judged primarily in terms of how much additional coverage for moderate- and low-income workers they deliver and at what cost in terms of lost revenue.

 

Description of Pension Provisions in the Ways and Means Bill

This section describes some of the provisions related to employer-sponsored pensions included in the tax legislation the House Ways and Means committee approved last fall and the full House is expected to consider the week of March 6. These provisions include several beneficial reforms in the pension laws. For example, they would require faster vesting than current law. Vesting occurs when a worker acquires a right to a pension benefit. Once a worker is vested, his or her pension benefit cannot be taken away if the worker switches jobs. If a worker whose employer has contributed $1,000 to the worker's pension leaves the firm before the worker is vested, the worker is not entitled to any pension benefit from this contribution.

Vesting is important to remove artificial barriers to labor mobility and to ensure equitable treatment of all employees. The Employee Retirement and Income Security Act of 1974 (ERISA) requires that employer contributions to a pension be vested in no more than five years. The legislation would reduce the maximum vesting period for 401(k) plans to three years, a useful change for some workers.(11) The legislation also simplifies the rules on rolling over account balances from one type of retirement account to another, which may increase pension portability for some workers, and includes notification requirements intended to ensure that workers understand the ramifications if their employers shift to so-called cash balance pension plans.(12)

But while the pension provisions are helpful in some respects, their main thrust is the relaxation of various rules intended to limit opportunities for high-income executives to enjoy pension benefits without providing similar benefits to rank-and-file employees. The apparent theory behind the proposals' changes in this area is that by liberalizing the rules for higher-income executives, the legislation will lead more businesses to adopt pension plans and thereby help their middle- and lower-income employees. No credible empirical evidence supports this theory, however, and analysis of the pension provisions in the Ways and Means bill suggests the "trickle-down" approach comes at a steep price. These provisions will likely do little, if anything, to increase pension coverage among rank-and-file workers, while providing significant benefits to higher-income workers (and also resulting in lost revenue for the federal government). The pending legislation represents an approach to pension policy that is both inefficient and regressive.

Among the provisions of the Ways and Means bill that would relax current pension rules for high-income individuals are the following.

 

Increased dollar limits for employee contributions

Workers are currently allowed to deposit a maximum of $10,500 out of their wages in a 401(k) account each year, a level that CBO inflation forecasts suggest will reach $11,500 by 2004 due to inflation indexing. The Ways and Means bill would boost this limit to $14,000 by 2004.(13) Only highly paid individuals generally make the $10,500 maximum contribution today; fewer than five percent of those with 401(k) plans now deposit the maximum $10,500 allowed, and the average compensation among those individuals is about $130,000.(14) Increasing the limit to $14,000 would benefit only those at or near the top of the compensation scale.

Increased maximum employer-employee contributions

Under current law, the $10,500 limit on deposits to a 401(k) account applies to employee contributions. Current law also requires that combined employer-employee contributions to 401(k)s and other defined contribution pension plans not exceed $30,000, or 25 percent of pay, whichever is lower. Provisions of the vetoed bill would raise the maximum combined employer-employee contribution to $40,000. This change is of benefit primarily to highly paid individuals. These provisions also would eliminate the requirement that such contributions not exceed 25 percent of pay.

Increased maximum considered compensation

Under current law, tax-favored pension benefits are based on compensation up to a maximum compensation level of $170,000.(15) For example, suppose a firm contributes two percent of wages to a defined contribution pension plan. The maximum contribution the firm can make for its executives is $3,400 (two percent of $170,000). An individual who is paid $200,000 a year could not receive an employer contribution equal to two percent of $200,000. Similarly, the maximum earnings that a firm can consider in determining benefits under a defined benefit pension plan is $170,000. Any earnings above that level do not accrue pension benefits under a defined benefit plan.

The legislation would raise the maximum compensation level that can be used in figuring pension contributions from $170,000 to $200,000. This would benefit only those paid more than $170,000 a year, the highest-paid one percent of workers. In addition, as explained below, this provision may induce some firms to make smaller contributions for their middle- and low-income employees than they would provide if the maximum limit remained at $170,000.

Increase in benefit payable under a defined benefit pension plan

Under current law, the allowable annual payment from a defined benefit pension plan is generally the lesser of: (a) the worker's average compensation; or (b) $135,000.(16) The legislation would increase the $135,000 limit to $160,000. This increase would benefit only those at the very top of the income distribution whose salaries are large enough to yield annual pension payments of more than $135,000.

Less rigorous nondiscrimination rules

Under current law, tax-preferred pension plans must not discriminate in favor of highly compensated employees. For example, pension plans generally are not allowed to use a more liberal formula in figuring employer pension contributions for high-income executives than other employees. The nondiscrimination rules play an important role in ensuring that tax preferences for pension plans serve the public purpose of boosting pensions among a wide array of workers, rather than just among highly compensated workers. The legislation eases the nondiscrimination rules.

The legislation also allows up to $5,600 in special contributions by older workers that are not subject to the nondiscrimination rules. These $5,600 in additional contributions by older workers would be on top of the maximum $14,000 in employee contributions that would otherwise be permitted. In other words, older workers would be allowed to deposit up to $19,600 (the $14,000 for all workers plus the $5,600 supplement for older workers) in their 401(k) plans, and the nondiscrimination rules would not apply to the $5,600 special supplement available only to older workers. Since the vast majority of older workers would continue to contribute less than the regular $14,000 limit and not use the special supplement, this supplement is likely to be used overwhelmingly by high-income individuals, making it important for it to be included in the nondiscrimination tests.

Relaxed top-heavy protections

Under current law, an additional set of rules apply to pension plans that, while meeting the nondiscrimination rules, deliver most of their benefits to company officers and owners. The "top-heavy" protections, as these safeguards are known, apply to plans in which 60 percent or more of the pension benefits accrue to such key employees. These protections require firms to take additional steps to protect middle- and low-income workers in such circumstances, through accelerated vesting and certain minimum contributions or benefits.

The legislation would relax the top-heavy safeguards by redefining who qualifies as a "key" employee, by selectively counting and not counting certain pension contributions in evaluating the top-heavy criteria, and by changing the rules governing the division of assets among family members. The legislation loosens the top-heavy protections for so-called "safe harbor" 401(k) plans, which are not subject to the nondiscrimination rules because of specific features of these plans.(17)

In addition, the legislation would exempt the special $5,600 supplement for contributions by older workers from the top-heavy rules. As noted above, such supplemental contributions also would be exempt from the nondiscrimination rules. Exempting these contributions from the top-heavy rules makes it still more likely that the special supplement would produce tax-preferred pension saving only for higher-income workers. Responsible simplification of the top-heavy protections may be sensible, but the approach embodied in the tax bill would endanger the effectiveness of these protections.

Reduced incentive for money purchase plans

The legislation also would significantly reduce firms' incentives to maintain the type of plan — known as a "money purchase" pension plan — that ensures a pension for many lower-income workers. Under a money purchase plan, a firm is required to contribute a fixed percentage of each worker's compensation to the plan, regardless of whether the worker himself (or herself) is contributing to an employer-sponsored plan. By contrast, under 401(k) plans, the percentage of compensation that the employer contributes varies; it depends on the percentage of compensation the employee contributes. Higher-income workers tend to contribute a larger percentage of pay, and hence they tend to secure employer contributions that equal a higher percentage of pay.(18)

Under current law, the combined employer-employee contribution to 401(k) plans may not exceed 15 percent of aggregate pay. A separate limitation under current law requires that combined employer-employee contributions to all defined contribution pension plans that a firm offers not exceed 25 percent of pay, or $30,000, whichever is lower. (In other words, the 25 percent cap and $30,000 limit under current law apply to total contributions to all defined contribution plans, while the 15 percent cap applies only to 401(k) and other profit-sharing plans.)(19)

If an employer wishes the combined contributions for top executives to equal 25 percent of compensation, the employer must provide both a 401(k) plan with a 15 percent limitation and a money purchase plan that contributes the other 10 percent of compensation. Under the money purchase plan, the employer would contribute an amount equal to 10 percent of pay for all employees, including those who earn low or modest wages and tend to make few, if any, contributions themselves. For many of these lower-wage workers, the money purchase plan can be much more important than a 401(k) plan.(20)

The legislation would change these rules in several ways. As noted earlier, it would eliminate the requirement that combined employer-employee contributions to all defined contribution plans not exceed 25 percent of pay and would raise from $30,000 to $40,000 the maximum combined contribution that can be made to all defined contribution plans on behalf of an employee. These changes would generally benefit only highly paid executives and business owners but would not necessarily cause firms to reduce use of money purchase plans.(21) The legislation does, however, contain another change that would reduce the need for firms to use money purchase plans, and in so doing risk substantial harm to low- and moderate-wage workers. The legislation would exclude employee contributions from the 15 percent limitation on contributions to 401(k) plans; this limitation henceforth would apply only to employer contributions, not to combined employer-employee contributions. This would effectively raise the 15 percent limit substantially and consequently greatly reduce the need for some firms to add a money purchase plan to enable their executives to secure the maximum pension contributions allowed. Over time, this provision could lead to a reduction in money purchase plans, causing many lower-wage workers to lose the one significant source of pension coverage they currently enjoy.

 

Impact of These Pension Provisions

The combined effect of these various pension changes in the Ways and Means Committee bill would be a significant increase in the tax-preferred benefits of high-income workers, with little expansion in pensions for the moderate- and low-income workers who most need to build savings for retirement. In fact, some of the changes could lead to reduced coverage for some low- and middle-income workers. (See table for a summary of the bill's provisions.)

Pension Provisions in the Ways and Means Committee Bill

Contributions to 401(k) plans

Maximum employee contribution raised from $10,500 to $14,000

Combined employer-employee contributions to defined contribution plans

Requirement that contributions not exceed 25% of pay eliminated

Maximum contribution limit raised from $30,000 to $40,000

Maximum considered compensation

Increased from $170,000 to $200,000

Annual maximum payment allowed under defined benefit plan

Increased from $135,000 to $160,000

Nondiscrimination rules

Secretary of the Treasury directed to relax these rules

Up to $5,600 in special contributions by older workers permitted; these contributions would not be subject to the nondiscrimination rules

Top-heavy rules

Definitions loosened and so-called "safe harbor" 401(k) plans exempted

Up to $5,600 in special contributions by older workers permitted, with such contributions exempted from the top-heavy rules

Incentives for money purchase plans

Reduced by making it easier to achieve maximum contributions for highly paid executives and business owners without a money purchase plan

As one example, consider a business owner with compensation of $250,000 who wants to have the business contribute at least $10,000 a year to his pension. Given the current compensation limit of $170,000, the business owner adopts a pension plan that contributes 6 percent of a worker's compensation. (The pension contribution for the owner is 6 percent of the $170,000 limit, or a little over $10,000.) The pension contribution for other employees in the firm also is 6 percent of their compensation. If the maximum compensation level used in figuring pension contributions were increased to $200,000 as the legislation provides, the business owner could reduce the contribution rate for his employees to 5 percent and still have the firm contribute $10,000 to his pension.

All of the other employees in the firm, as well, would then receive contributions of 5 percent of compensation, rather than 6 percent. The employer contribution for an employee who earns $40,000 would drop from $2,400 (6 percent of $40,000) to $2,000 (5 percent of $40,000).

A number of the legislation's other pension provisions also could harm low- and middle-income workers. These include the provisions loosening the non-discrimination and top-heavy protections against disproportionate pension benefits for higher-income workers, as well as the provisions reducing the need for firms to offer money-purchase plans.

Many of these provisions are drawn from pension legislation that House Reps. Bob Portman and Ben Cardin introduced last year (H.R. 1102). In analyzing the effects of that legislation, Norman Stein, the Douglas Arant Professor of Law at the University of Alabama School of Law, concluded, "Although there are good things in the Portman-Cardin bill, some of its major provisions would not contribute enough to good retirement policy to justify their substantial price tags, and other of its provisions would harm more people than they would help. It would be ironic and deeply unfortunate if this well-intentioned but flawed legislation is enacted, for it may well be remembered as a retirement reduction act. I fear that this possibility, an illustration of the law of unintended consequence, is all too real."(22)

Similarly, Dianne Bennett, the president of a 170-lawyer law firm in Buffalo and a leading authority on pension law, has cautioned, "In spite of the laudable goals, I am convinced that most of the significant provisions of the Portman-Cardin bill will have the opposite effect. The most significant provisions will shift tax benefits to higher-income taxpayers. Virtually every significant provision is designed to grant tax benefits to participants in plans who earn more than $100,000 annually. The likely result is to shift the tax burden from higher-income taxpayers to lower-income taxpayers and to take benefits away from middle- and lower-income taxpayers. I believe it is likely that the effects of Portman-Cardin, were it to pass, would be to expand retirement plans that benefit only owners of businesses and to reduce dramatically the benefits granted to non-owner employees in small business plans."(23)

 

Conclusion

Both to build national saving and to strengthen retirement security, pension reforms should be directed primarily at expanding pension coverage among moderate- and low-income workers. Most of the pension benefits in the Ways and Means Committee bill, the tax bill the House is expected to consider the week of March 6, would accrue instead to higher-income workers who already enjoy high rates of pension coverage. Indeed, an analysis of the pension provisions of the vetoed tax bill — the provisions that are incorporated into the Ways and Means bill with minor changes — found that 96.5 percent of the tax benefits these provisions would produce would accrue to individuals in the top 20 percent of the income distribution, the same people who already receive two-thirds of the pension benefits under current law. Moreover, certain components of the legislation could result in reduced pension coverage for some low- and middle-income workers. The legislation represents an inefficient and regressive approach to pension policy.


End notes:

1. Peter Orszag is President of Sebago Associates, Inc., an economics consulting firm, and lecturer in economics at the University of California, Berkeley. From 1995 to 1998, he served as Special Assistant to the President for Economic Policy and as Senior Economist on the Council of Economic Advisers. Iris Lav and Robert Greenstein are Deputy Director and Executive Director, respectively, of the Center on Budget and Policy Priorities. This is a revised and updated version of a Center analysis issued in October 1999 of the pension provisions of the vetoed tax legislation.

2. U.S. Department of Labor, Social Security Administration, Small Business Administration, and Pension Benefit Guarantee Corporation, Pension and Health Benefits for American Workers, 1994.

3. Social Security Administration, Office of Research, Evaluation, and Statistics, Fast Facts and Figures about Social Security (1998), page 6.

4. U.S. Department of Labor, Social Security Administration, Small Business Administration, and Pension Benefit Guaranty Corporation, Pension and Health Benefits of American Workers, 1994, Table B11. "Covered" means that the employee participated in any type of employment-based pension plan, including defined benefit plans, 401(k) type plans, deferred profit sharing plans, and stock plans. Pension coverage is even lower among part-time workers. Only 12 percent of part-time workers enjoy pension coverage, compared to 50 percent of full-time workers.

5. U.S. Department of Labor, Social Security Administration, Small Business Administration, and Pension Benefit Guaranty Corporation, Pension and Health Benefits of American Workers, 1994, Table B9.

6. For example, the legislation created the SIMPLE, a special 401(k) plan for small businesses that is easier to set up and administer than other 401(k) plans.

7. If the revenue loss is fully offset through other fiscal measures, then the net impact on national saving is simply the change in private saving. In this case, public saving would be unchanged.

8. Economists continue to debate the impact on private saving from existing pension incentives. Most economists agree, however, that whatever the overall effect, focusing incentives on those with fewer opportunities to shift assets from taxable to non-taxable forms is likely to produce a larger increase in private saving for any given reduction in government revenue. For a discussion of the impact of existing tax preferences, see Eric Engen, William Gale, and John Karl Scholz, "Personal Retirement Saving Programs and Asset Accumulation: Reconciling the Evidence," National Bureau of Economic Research Working Paper 5599 (May 1996), and James Poterba, Steven Venti, and David Wise, "Do 401(k) Contributions Crowd Out Other Personal Saving?" Journal of Public Economics, Volume 58, 1995, pages 1-32.

9. The revenue loss from the net exclusion of pension contributions and earnings in FY 1999 is estimated to be $72.4 billion for employer-provided plans, $10.8 billion for Individual Retirement Accounts, and $3.8 billion for Keogh plans. The exclusion of employer contributions for medical insurance and medical care is estimated to cost $76.2 billion in FY 1999. See Budget of the United States Fiscal Year 1999: Analytical Perspectives, Table 5-1, page 92.

10. For an overview of the tax provisions affecting employer-provided pensions, see Joint Committee on Taxation, Overview of Present-Law Tax Rules and Issues Relating to Employer-Sponsored Retirement Plans (JCX-16-99), March 22, 1999.

11. Alternative rules apply under both current law and the legislation if the vesting occurs gradually. The vesting improvements under the legislation, however, do not apply to all workers (only 27 percent of full-time workers in 1993 were covered by a 401(k) plan), and their benefit to many covered workers may be limited (since many firms offering 401(k) plans already provide faster vesting than current law requires).

12. In a cash balance plan, employers make annual contributions to an account in a worker's name. The account then earns interest at some specified rate, often tied to the Treasury bond yield, but the interest rate is not necessarily tied to the actual investment earnings of the pension trust. Despite its similarities to a defined contribution plan, the cash balance plan is formally a defined benefit plan. In general, younger workers benefit and older workers lose from a shift from a traditional defined benefit plan to a cash balance plan.

13. In addition, the legislation would raise the current limits on contributions to other defined contribution plans, including 457 plans (for state and local government workers) and SIMPLE 401(k)s, and also create special higher limits for workers aged 50 and over. It also would create a Roth 401(k) plan, called a 401(k) "plus" account, which would allow taxpayers to contribute taxable dollars to a 401(k) plan and then receive tax-free distributions upon retirement (much as under a Roth IRA plan). Such a system raises the effective contribution limit further. For example, $14,000 deposited into a conventional 401(k) plan today, accumulated at a 5 percent real tax-free rate of return over 20 years and then taxed at a 31 percent rate upon withdrawal yields $25,630 in after-tax income in 20 years. But $14,000 of after-tax dollars put into a Roth 401(k) today, accumulated at a 5 percent real tax-free rate of return over 20 years and then distributed tax-free yields $37,146 after-tax in 20 years. The equivalent deposit in a traditional 401(k) plan today, to obtain the same $37,146 after-tax in 20 years, would be $20,290, an amount that exceeds the permitted limits on 401(k) plans.

14. Given the limitation on combined employer-employee contributions of 25 percent of pay (see below), workers with earnings of less than $42,000 are not eligible to contribute $10,500 to their 401(k). Furthermore, average contribution rates tend to be higher for higher-income workers than for lower-income workers, making it even more likely that the $10,500 limit is relevant only for higher-income workers. For a discussion of contribution rates to 401(k) plans by income, see General Accounting Office, "401(k) Pension Plans: Many Take Advantage of Opportunities to Ensure Adequate Retirement Income," GAO/HEHS-96-176, 1996.

15. The compensation ceiling applies to all qualified retirement plans, including both defined contribution and defined benefit plans.

16. Under current law, the $135,000 limit is adjusted down or up (respectively) if payments from the plan begin before or after the full benefit age under Social Security. The bill would modify these rules.

17. To qualify for the safe-harbor provision, the employer must either match on a dollar-for-dollar basis the first three percent of pay the employee contributes — and contribute an additional 50 cents for each dollar the employer contributes on the next two percent of pay — or contribute at least three percent of pay for each non-highly compensated employee, regardless of whether the employee makes elective contributions on his or her own. The safe-harbor rules also include vesting and notification requirements.

18. Higher-income workers contribute a larger percentage of compensation to 401(k) plans than do lower-income workers. For example, among workers aged 18 to 64 with a 401(k) plan in 1992, the average contribution rate was 3.7 percent of pay for those with household income less than $25,000 and 7.9 percent of pay for those with household income exceeding $75,000. General Accounting Office, "401(k) Pension Plans: Many Take Advantage of Opportunities to Ensure Adequate Retirement Income," GAO/HEHS-96-176, 1996, Table II.4.

19. Technically, the 25 percent cap applies to each individual, whereas the 15 percent cap applies to the ratio of aggregate contributions to aggregate compensation. However, since the 25 percent cap applies to each individual, it also imposes a 25 percent cap on the ratio of aggregate contributions to aggregate compensation. As noted in the text above, the legislation would eliminate the 25 percent cap.

20. In 1992, some 8.7 percent of workers with household incomes below $25,000 were covered by defined contribution plans other than 401(k), 403(b), and 457 plans. A large share of these 8.7 percent of workers participated in money purchase plans. By comparison, only 3.5 percent of workers with household incomes below $25,000 participated in a 401(k), 403(b), or 457 plan.

21. The increase in the maximum combined contributions to $40,000 may increase the incentive for firms to have a money purchase plan, since the maximum pension contribution for executives would be higher, and more of a supplement under a money purchase plan would be necessary to reach the maximum allowed limit for all defined contribution plans. At the same time, however, the provision of the bill that would increase maximum considered compensation from $170,000 to $200,000 would effectively raise the total amount that could be contributed to a 401(k) plan even with the 15 percent of aggregate pay limit and therefore may decrease the incentive for firms to operate a money purchase plan.

22. Norman Stein, Testimony before the Subcommittee on Oversight, House Committee on Ways and Means, March 23, 1999.

23. Dianne Bennett, written testimony submitted to the Subcommittee on Oversight, House Committee on Ways and Means, March 22, 1999.