Revised May 1, 2000

Would Raising IRA Contribution Limits Bolster Retirement Security 
For Lower– and Middle-income Families or Is There a Better Way?


by Peter Orszag and Jonathan Orszag(1)

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Several pieces of legislation currently before Congress would raise the maximum amount that can be contributed to an Individual Retirement Account (or IRA) from $2,000 to $5,000 for an individual and from $4,000 to $10,000 for a married couple. This increase apparently is intended by its sponsors to boost retirement saving for middle-class families and to increase national saving.

The proposal would have virtually no effect, however, on families and individuals who do not make any deposits in IRAs under current law or who deposit less than the current $2,000 limit. This proposal would directly benefit only those already making the $2,000 maximum contribution; these are the sole households the current $2,000 limit affects. A recent analysis prepared by the Office of Tax Analysis at the Treasury Department found that only four percent of all taxpayers who were eligible for conventional IRAs in 1995 were at the $2,000 contribution limit.(2) Those at the limit almost certainly are among the most-affluent of the taxpayers eligible for IRAs.(3)

Only four percent of taxpayers eligible for IRAs contributed $2,000 in 1995; these are the people the IRA proposal would help.

The analysis prepared by Treasury's Office of Tax Analysis also found that 93 percent of taxpayers eligible to make deductible contributions to a conventional IRA did not make any IRA contribution in 1995. Raising the IRA contribution limit would likely not do anything to increase the amount these taxpayers save for retirement. This proposal thus would have virtually no effect on the vast majority of middle-class families, despite its cost of approximately $18 billion over five years and more than $40 billion over 10 years.

The tax subsidies for retirement saving the federal government currently provides already are skewed heavily toward more-affluent individuals. Treasury data show that two-thirds of the existing tax subsidies for retirement saving (including both private pensions and IRAs) accrue to the top 20 percent of the population. Only 12 percent of these tax subsidies accrue to the bottom 60 percent of the population. This suggests that any new retirement saving subsidies should be focused primarily on lower- and middle-income families.

The proposal to raise the IRA contribution limit to $5,000, however, would further skew the distribution of tax subsidies for retirement saving. An analysis by the Institute on Taxation and Economic Policy finds that 70 percent of the tax subsidies for retirement saving that would be provided by raising the IRA limit to $5,000 would accrue to the 20 percent of the population with the highest incomes, the group that already receives the bulk of retirement tax subsidies under current law and that possesses the bulk of retirement savings. By contrast, the bottom 60 percent of the population would receive only 5.5 percent of the tax subsidies this proposal would provide.

 The distribution of IRA tax subsidies partly reflects the fact that the income limits for deductible IRA contributions do not apply to individuals not covered by an employer-sponsored pension plan. Nearly 30 percent of IRA contributors in 1995 were individuals whose incomes exceeded the IRA limits, such as small-business owners and executives and independent professionals who are not covered by an employer plan. These individuals made nearly 40 percent of the IRA contributions that year. They are the people who could most readily afford to raise their IRA contributions to $5,000 a year.

The proposal also raises other serious concerns.

Currently, a small-business owner with a high income can deposit $4,000 a year in a conventional IRA ($2,000 for the owner and $2,000 for the owner's spouse) if the small business has no pension plan. If the owner wants to set aside a larger amount, say $10,000, in tax-favored retirement savings, the owner must establish an employer pension plan and make the contributions through the plan. If the IRA contribution limits are raised to $5,000, however, the owner will be able to use IRAs to put away $10,000 a year in tax-advantaged retirement saving without having to incur the expense of operating and making contributions to an employer-sponsored pension plan for the firm's employees. Moreover, the owner would be able to take advantage of the increased contribution limits for conventional IRAs only if the firm did not offer a plan.

This would provide a strong inducement for small-business owners who otherwise might establish pension plans not to do so. Taking advantage of an increase to $5,000 in the IRA contribution limits would enable the owner to secure large tax-favored retirement contributions for himself or herself and a spouse without the administrative complexity of an employer-based pension plan. The IRA proposal has a strong potential to erode rather than strengthen retirement security for employees in small businesses.

Retirement Saving Accounts

The Administration's proposal to establish "retirement savings accounts" (RSAs) represents an alternative way to boost retirement saving. The RSA proposal does not pose the array of problems the IRA proposal does. Under the RSA approach, the Treasury would provide tax credits to match contributions that married couples with incomes up to $80,000 a year (and individuals with incomes up to $40,000) make to retirement saving accounts. The matching rate would be highest for lower-income families and gradually phase down as income rose.

Fact and Fiction in Merrill Lynch’s Promotion of the IRA Proposal

Merrill Lynch recently ran a full-page advertisement in Congressional Quarterly and National Journal promoting the proposals to raise the IRA contribution limit to $5,000. The advertisement correctly notes that despite the economic boom, many Americans do not appear to be saving enough for retirement. But it includes two misleading statements.

First, the advertisement states that for "years the IRA has been an invaluable savings tool for over 30 million households of working Americans." This may create the impression that 30 million Americans a year are making deposits into IRAs. In fact, Treasury data show that the number of taxpayers making IRA contributions is about five million a year, or one-sixth of the 30 million number. (The most recent reliable data available show that 5.3 million taxpayers made contributions to IRAs in 1995.) The 30 million figure appears to reflect the number of people who have contributed to IRAs over a period of nearly 20 years, including large numbers of higher-income individuals who contributed in the early 1980s when there were no income limits on IRAs.

The advertisement also claims that "raising the IRA limit to $5,000 would encourage more savings and would especially benefit working women, whose savings needs are more acute because they are often in and out of the workforce to raise children." As this paper shows, however, the increase in the limit to $5,000 would have no effect on the vast majority of taxpayers, including both working men and working women. Only a very small percentage of working women would receive any benefit from the proposal.

Nor is there reason to believe there would be substantial differences between men and women in terms of the impact of the proposed IRA expansion. One recent report from the Employee Benefit Research Institute concluded that "working men and women are preparing similarly for retirement." a In addition, the percentage of high-income women who are not covered by an employer-provided plan – and therefore eligible to make IRA contributions regardless of income – is similar to the percentage of high-income men not covered by an employer-provided plan.

a Pamela Ostuw, "Retirement Planning and Saving among Women: Results from the 1999 Women’s Retirement Confidence Survey," January 2000.

Compared to the proposal to raise the IRA contribution limits, the RSA proposal represents a far more efficacious way to increase retirement saving among middle- and lower-income working families. While the IRA proposal would directly benefit only a very small number of middle-income families —  those that already deposit the full $2,000 in an IRA —  and would give 70 percent of its tax subsidies for retirement saving to the top 20 percent of the population, the RSA tax subsidies would be focused heavily on middle- and lower-income families and individuals. Analysis of a somewhat similar proposal suggests that only about 20 percent of the RSA subsidies would accrue to individuals in the top 20 percent of the population; roughly 80 percent of the subsidies would go to the bottom four-fifths of the population.

As noted, raising the IRA contribution limit would have virtually no effect in increasing participation rates in IRAs among those not participating under current IRA rules and also would not be likely to affect those who participate in IRAs but contribute less than $2,000. IRA depositors who cannot afford to set aside $2,000 also cannot afford to set aside $5,000. By contrast, RSAs would provide subsidies to modest savers to increase the amounts they save by matching contributions they make, starting with the first dollar they save. As this  analysis demonstrates, for most couples with incomes below $80,000 and most individuals with incomes below $40,000, RSAs would provide a substantially larger subsidy for retirement saving —  and a much more powerful inducement for such saving —  than raising the IRA contribution limit would.

The Administration's Retirement Saving Accounts proposal would be more likely to add to national saving — and would pose less danger of inducing small businesses not to offer pension plans — than the IRA proposal.

Contributions to RSAs also would be more likely to add to national saving than contributions to IRAs, an important issue since increasing national saving should be one of the nation's top priorities in preparing for the retirement of the baby-boom generation. As noted, increasing the IRA limit would result in a large portion of the new IRA tax subsidies going to more-affluent taxpayers who can shift funds from existing saving vehicles, rather than increase the amount they save out of their income. By contrast, the RSA proposal would concentrate its subsidies on lower- and middle-income families; such families are much less likely to have substantial financial assets to shift. Deposits made in a saving vehicle such as RSAs consequently are more likely to represent new saving than the increased amounts that would be deposited in IRA accounts if the IRA contribution limit is raised.

The RSA proposal also would pose less danger of creating incentives for small businesses not to offer employer pension plans. An increase in the IRA contribution limits could obviate the need for small-business owners to offer employer plans in order to build substantial tax-advantaged retirement accounts for themselves. RSAs would not have such an effect because they would not be available to business owners (or anyone else) with incomes exceeding $80,000. Since RSAs would not provide retirement tax subsidies for well-compensated business owners or other high-income individuals, RSAs could not replace employer pension contributions for a business owner and a firm's top executives. Thus, the availability of RSAs would not provide an incentive to an owner to drop or fail to initiate a plan.

The IRA and RSA proposals have roughly similar costs. Proposals to raise the IRA contribution limit to $5,000 would cost more than $40 billion over 10 years.(4) The Administration's RSA proposal would cost $61.5 billion over 10 years but could be modified to cost somewhat less than that, and the costs of the RSA proposal appear to grow less rapidly after the end of the initial 10-year period than the costs of the IRA proposal. The costs of the two approaches are in the same general range. But their effects are decidedly different.

The conclusions from this analysis are clear. Policymakers who are interested in devoting roughly $50 billion over 10 years in tax subsidies to retirement savings —  and who want to promote retirement security among lower- and middle-income families and boost national saving —  would be much better off pursuing an RSA-type of approach than increasing the IRA contribution limit.

End Notes:

1. Peter R. 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. Jonathan M. Orszag is Managing Director of Sebago Associates. He previously served as Director of the Office of Policy and Strategic Planning at the Department of Commerce, and was an Economic Policy Advisor on the National Economic Council at the White House.

2. Robert Carroll, "IRAs and the Tax Reform Act of 1997," Office of Tax Analysis, Department of the Treasury, January 2000. The paper notes that reliable and comprehensive data on Roth IRA contributions are not yet available.

3. It may be noted that those at the limit tend to be older than other taxpayers. Among the working-age population, both income and asset-holdings tend to rise with age.

4. Last year, the Joint Tax Committee placed the cost of H.R. 802, a bill that raises the IRA contribution limit to $5,000, at $18 billion over five years. Based on the Joint Tax Committee's estimate of the bill's cost in the fifth year, the legislation would cost more than $40 billion over 10 years.