May 18, 2005


by Joel Friedman and Robert Greenstein

PDF of full report

Fact Sheet: Ways And Means Social Security Bill Could Include Costly, Poorly Targeted Retirement Tax Proposals

View Additional Reports

If you cannot access the files through the links, right-click on the underlined text, click "Save Link As," download to your directory, and open the document in Adobe Acrobat Reader.

Ways and Means Chairman Bill Thomas has suggested that new tax cuts to promote retirement savings should be considered as part of the effort to reform Social Security.  Chairman Thomas has expressed interest in a range of proposals.[1]

A number of retirement-related tax proposals have strong proponents on Capitol Hill, in the financial securities industry, and among other interest groups.  Among the proposals being pushed are measures to raise the amount that workers can contribute to employer-sponsored 401(k)s and Individual Retirement Accounts, to remove the income limits that apply to IRAs, and to create tax-sheltered accounts for health care costs incurred in retirement.

Most such proposals would be very costly, especially in future decades when the baby boomers will retire in large numbers and the nation faces deficits of unprecedented magnitude.  In addition, most such proposals would provide the bulk of their tax benefits to high-income households that do not need help putting away enough money for retirement, while doing little or nothing to assist low- and moderate-income households to save more for retirement.

This analysis explores proposals to eliminate income limits on IRAs, raise contribution limits on IRAs and 401(k)s, and establish “health IRAs” or similar mechanisms.


Eliminating Income Limits on IRAs

Removing the income limits on IRAs is at the core of the Administration’s “Retirement Savings Accounts” proposal.  The RSA proposal is contained in pension legislation that Rep. Rob Portman introduced before he left the House to become U. S. Trade Representative, and is likely to be considered for inclusion in a Social Security bill.

Raising Contribution Limits on IRAs and 401(k)s

People under 50 currently can make tax-deductible contributions of up to $14,000 a year to a 401(k).  People 50 and over can contribute $18,000 a year.  The $14,000 and $18,000 limits rise to $15,000 and $20,000 in 2006.  These are the limits on employee contributions; firms can, and generally do, make substantial additional contributions to executives’ 401(k)s.  There is no income limit on who can make tax-deductible contributions to 401(k)s.

People under 50 who are eligible for IRAs currently can contribute $4,000 a year ($8,000 for a couple).  These limits rise to $5,000 ($10,000 for a couple) in 2008.  People 50 and over can contribute somewhat more; starting in 2008, they will be able to contribute $6,000 ($12,000 for a couple).

These limits were raised substantially by the 2001 tax-cut legislation.  Chairman Thomas is now reported, however, to be considering proposals to raise these limits still higher. 

Health IRAs and Similar Tax Shelters

An array of tax-shelter proposals related to health care costs in retirement also could be considered for inclusion in a Social Security bill.  Various proposals that have influential backers, such as Merrill Lynch or Fidelity, would allow people to make substantial tax-deductible contributions to investment accounts, receive earnings on the accounts that are sheltered from taxation, and then withdraw funds tax free in retirement as long as the amounts withdrawn do not exceed the retiree’s out-of-pocket health care costs in that year.

This group of proposals would obliterate what until now has been a fundamental principle of retirement tax policy: that tax-advantaged retirement accounts can feature either tax-deductible contributions or tax-free withdrawals, but not both.  (The Health Savings Accounts established by the 2003 prescription-drug legislation include both tax-deductible contributions and tax-free withdrawals, but no retirement tax provisions include such a feature.)

The proposals in question include the following:

These proposals would be very costly in future decades, when substantial sums that would otherwise be subject to tax would be withdrawn in retirement on a tax-free basis.  Long-term budget projections, such as those made by CBO, GAO, and OMB, show massive budget deficits in future decades; those projections include about $3.8 trillion in revenue (in present value) which is slated to be collected on withdrawals from IRAs and 401(k)s between now and 2040.  Health-related retirement tax proposals that would convert a portion of the withdrawals from tax-deductible IRAs and 401(k)s to tax-free status would likely result in a significant share of IRA and 401(k) withdrawals becoming tax free and thereby make the long-term fiscal picture markedly worse than it already is.  (As discussed in the box on page 10, health IRAs also would reduce state revenues.)

In addition, these proposals would represent lucrative tax shelters for high-income people, who generally do not need increased government subsidies to meet their health care costs in retirement, while doing relatively little for retirees with modest incomes.

A Tax Deduction for Long-term Care Insurance

Another proposal expected to be considered for inclusion in a Social Security bill would provide a new tax deduction for the purchase of long-term care insurance.  Such a deduction would be of little value to low- and middle-income families and would likely be ineffective in helping them secure long-term care insurance.  Its benefits would disproportionately go to high-income individuals, who least need government subsidies to help them afford long-term care insurance.

  • Long-term care insurance can be very expensive.  The people for whom it is most out of reach are low- and middle-income families that do not earn enough to owe income tax or are in the 10 percent or 15 percent income tax brackets.  About three-quarters of all tax filers fall into these categories.

    Low-income families that do not earn enough to incur income tax liability would receive no benefit from the proposed deduction.  For middle-class families in the 10 percent or 15 percent tax brackets, the deduction would defray no more than 10 cents to 15 cents of each dollar they would have to spend to purchase a long-term care insurance policy.  The deduction thus would not make this insurance affordable for most of these people.
  • The deduction would be of greatest value to high-income taxpayers.  The higher an individual’s tax bracket, the greater the subsidy the deduction would provide.  For individuals in the highest tax bracket, the deduction would subsidize 35 percent of the cost of long-term insurance.

The proposal thus would consume a substantial amount of federal budget resources to provide new subsidies for long-term care primarily to Americans who least need such subsidies, while doing little to address the large long-term care costs that millions of ordinary Americans can encounter.

Indeed, low- and middle-income families could end up with less health care assistance under this proposal.  It is likely they ultimately would have to bear a significant share of the burden of the higher deficits and debt these proposals would bring.  The hefty revenue losses involved could intensify pressures for future budget cuts in programs such as Medicare and Medicaid.  People of modest or ordinary means could lose more than they gained, while people at the top of the income scale reaped windfalls from a lucrative new tax shelter.

If Congress wishes to devote more resources to reducing the health care costs of retirees, it should do so transparently through the normal budget process.  These proposals, by contrast, mask their true cost by using backloaded tax breaks to deliver health care subsidies, primarily to people with a questionable need for such subsidies.


Proposals Would Do Little To Spur New Saving

Research has shown that high-income households are much more likely than other households to save adequately for their retirement, even in the absence of tax incentives.  The research indicates that high-income people would tend to use new pension tax breaks primarily as a way to shelter more income from taxation.  They would primarily respond to these tax breaks not by increasing the total amount they save but by shifting existing savings from taxable accounts to tax-advantaged accounts.  As a result, raising the IRA income limits or increasing the IRA or 401(k) contribution limits would likely do little to encourage new private saving.

These tax breaks would, however, increase the federal budget deficit, unless their high costs were offset on an ongoing basis.  They thus would be likely to reduce national saving.

National saving is the sum of private saving and either public saving (government surpluses) or public dissaving (government deficits, which soak up private savings).  If the amount by which a tax proposal increases the deficit exceeds the amount of new private saving the proposal induces, then the proposal reduces overall national saving.  That would likely be the effect of proposals to eliminate the IRA income limit, raise IRA or 401(k) contribution limits, or create health IRAs, unless the cost of these tax breaks were offset on an ongoing basis (i.e., not just over the first ten years.)  Lower national saving would likely have a negative impact on long-term economic growth.


Proposals Would Exacerbate Problems of Current Pension System

Existing tax incentives for pension saving are “upside down”:  they are worth the most to people at very high income levels — who are the most likely to save on their own anyway — and worth the least to lower income individuals, who most need to save more for retirement.[9]  Tax Policy Center analyses show that under current law, the top 20 percent of households receives 70 percent of the tax breaks associated with 401(k)s and IRAs.  In contrast, the bottom 60 percent of households receives only 11 percent of these retirement tax subsidies.  Moreover, nearly all — 95 percent — of those who did not contribute to retirement accounts in 1997 had incomes of less than $80,000.[10]

Raising contribution limits on 401(k)s or IRAs, or removing the income limit on IRAs, would make pension tax incentives even more lopsided, skewing tax subsidies for retirement saving even more heavily to those at the top of the income scale.  Such proposals would do virtually nothing either to encourage ordinary workers who do not participate in a 401(k) plan or an IRA to save for their retirement or to provide incentives for low- and moderate-income workers to save more.  Moreover, as noted above, some of these proposals would provide incentives to business owners to scale back employer contributions to a retirement plan or not to offer a plan in the first place, so the net effect on retirement saving by ordinary workers could even be negative.

Would Eliminating IRA Income Limits for High-Income Households
Lead to More Retirement Savings by Non-affluent Households?

 Some proponents of eliminating income limits on IRAs argue that doing so would lead financial services firms to advertise IRAs more aggressively, and that such advertising would, in turn, encourage moderate-income households to save more.  Brookings Institution economists William Gale and Peter Orszag have found this claim to be without much foundation.

Gale and Orszag have noted that when such advertisements were used prior to 1986 — when there were no income limits on tax-deductible IRAs — much of the advertising was “designed to induce asset shifting among higher earners rather than new saving among lower earners.”*  They have shown that some of the ads run in those years explicitly declared that people could make money by shifting $2,000 (then the maximum IRA contribution allowed) “from your right pants pocket to your left pants pocket,” with the left pocket being an IRA.

Gale and Orszag also observed that the higher levels of IRA contributions made between 1981 and 1986, the period when there were no income limits on tax-deductible IRAs, appear to have consisted largely of shifts of assets from taxable to tax-advantaged accounts.  The Congressional Research Service found in a similar vein that, in the period from 1981-1986, “there was no overall increase in the savings rate...despite large contributions to IRAs.”
* Gale and Orszag, “An Unwise Deal.” The ad cited here ran in The New York Times.

Proposals Would Likely More than Offset Social Security Benefit Reductions for High-income Individuals But Not for Average Families

Under the sliding-scale reductions in Social Security benefits that President Bush has proposed, middle and high earners would face larger benefit reductions than low earners.  In comments in late April, Chairman Thomas (and Social Security Subcommittee chairman Jim McCrery) suggested that the inclusion of pension-related tax breaks in Social Security legislation could compensate middle- and upper-income workers for their larger Social Security benefit reductions.

Proposals such as raising IRA and 401(k) contribution limits, eliminating IRA income limits, and creating health IRAs, however, would primarily benefit those at the top of the income spectrum while doing little or nothing to offset the benefit reductions in Social Security benefits that ordinary middle-income workers would face.

In recent testimony before the House Ways and Means Committee, Jason Furman (an economist at New York University and a senior fellow at the Center on Budget and Policy Priorities) used two hypothetical families — the Smiths and the Jones — to illustrate the combined effects of expanded RSA-style tax incentives and the Social Security benefit reductions the President has proposed.[11]


Steps To Improve Retirement Savings Should Target Those Most in Need

Most households nearing retirement have relatively low levels of savings.  Using data from the Federal Reserve’s Survey of Consumer of Finances, Brookings economist Peter Orszag estimates that the median value of assets in 401(k)s and IRAs for households nearing retirement (ages 55-59) was only about $10,000 in 2001.[12]

This problem is particularly acute for lower-income households.  Households in the top 10 percent of the income spectrum hold more than half of all assets in 401(k)s and IRAs.  Those in the bottom 40 percent of the income spectrum hold only about 5 percent of these assets.

There are a range of proposals that could help low- and middle-income families save more for retirement, such as making contributions to 401(k) plans more automatic, allowing workers to split tax refunds so they can deposit a portion of their refund into a retirement account, extending and improving the existing Saver’s Credit (which is slated to expire at the end of 2006), and exempting retirement accounts from the asset tests used in means-tested assistance programs.[13]  These proposals would help raise the personal savings of families most in need and also would contribute to higher national savings, particularly if their costs were offset.

Proposals to raise income and contribution limits, on the other hand — or to create health-related tax shelters that feature both tax-deductible contributions and tax-free withdrawals — would move the retirement system in the wrong direction.  Policymakers should not adopt such proposals.  Moreover, they should resist attempts to couple the misguided and expensive proposals with more sensible reforms, as doing so would make the price of the desirable changes too high.

Proposals Could Cause Large Revenue Losses for States

Most of the additional tax benefits for retirement accounts and health care that the Ways and Means Committee may consider have implications for state revenues.  Federal tax changes often affect state tax revenue because most states use federal definitions of income and other features of the federal tax code as the basis for their own taxation.

Retirement Savings Accounts

The Administration’s Retirement Savings Account proposal would replace IRAs with RSAs, which essentially are Roth IRAs without an income limit.  There would be a revenue gain at the federal and state levels in the first few years, because individuals would move balances in their traditional IRAs into the new RSAs and pay taxes on those balances.  (These taxes otherwise would have been paid when they withdrew the funds in retirement.)  This would be followed by large revenue losses beginning a few years from now and growing every year thereafter for several decades.

All states with an income tax other than Massachusetts and Pennsylvania currently conform in most respects to the federal tax treatment of Roth IRAs (and Pennsylvania accords them treatment nearly parallel to the federal treatment).  States are likely to feel substantial pressure to continue providing a tax break for savings.  If RSAs are enacted, states are very likely to conform to the federal tax treatment of them, just as they currently conform to the federal tax treatment of IRAs.

The fact that the revenue losses would be postponed for several years could make conformity difficult to resist even for states, such as California and Virginia, that do not automatically conform to federal income tax changes.  The enticement of a short-term revenue gain would combine with the advantages of uniform national treatment on this type of provision to increase the probability of conformity.

Raising Contribution Limits in Retirement Plans

Other proposals would increase the amount a taxpayer could deposit annually in various types of retirement plans such as 401(k)s and IRAs.  Just as deposits to qualified retirement accounts are excluded from income for federal tax purposes, they also are excluded from income in all states except Pennsylvania.  (New Jersey allows an exclusion for 401(k)s but not for other pension plan types.)

Health IRAs

Proposed health IRAs would allow a portion of funds from tax-deductible retirement savings plans such as 401(k)s and IRAs to be withdrawn tax-free after retirement to pay for out-of-pocket medical costs.  These proposals pose still another threat to state revenues.  States would lose large amounts of tax revenue at a time when they will be struggling to meet the rising costs of Medicaid for an aging population. 

The Bond Market

In addition, all states — including those that do not levy income taxes — could experience increased costs as a result of these proposals.  Tax-advantaged savings vehicles that can be used by high-income taxpayers provide such taxpayers with an alternative to purchasing tax-exempt bonds issued by states and localities.  As new types of tax-free savings opportunities compete with tax-exempt bonds, it is likely that states and localities would have to offer higher interest rates to attract sufficient investment in their bonds.


Income and Contribution Limits for IRAs and 401(k)s Under Current Law

This paper examines proposals related to Individual Retirement Accounts and employer-sponsored defined contribution plans, such as 401(k)s.  There are currently two types of IRAs — a traditional IRA and a Roth IRA.  Traditional IRAs and 401(k)s provide a tax deduction up-front at the time the contribution is made; withdrawals from the accounts during retirement are taxed as ordinary income.  Roth IRAs are structured differently; contributions are not tax deductible, but withdrawals from Roth IRAs are tax free.  (That is why Roth IRAs are often referred to as “backloaded;” the revenue losses associated with these accounts do not occur until many years in the future, when the funds are withdrawn.)  Under both types of IRAs, as well as 401(k)s, assets in the accounts are allowed to grow from year to year without the earnings on the accounts being taxed.

Income Limits:  Defined contribution plans such as 401(k)s are only available through an employer.  Although employers may place restrictions on participation (such as a minimum number of years of employment), 401(k)s are available to earners at all income levels.  IRAs are not linked to employers.  But unlike 401(k)s, contributions to IRAs are available only to workers with incomes below certain levels. 

Contribution Limits:  The 2001 tax-cut package substantially increased the contribution limits for both 401(k)s and IRAs.  In 2001, the contribution limit for 401(k)s was $10,500 per worker.  The 2001 tax-cut package increased the limit to $14,000 by 2005; the limit rises to $15,000 in 2006.  For traditional and Roth IRAs, the contribution limit was increased to $4,000 by 2005, up from the previous maximum of $2,000, and will rise to $5,000 in 2008.  Couples generally can contribute twice these amounts to IRAs regardless of whether a spouse works.

The contribution limits are higher for people aged 50 and over.  Starting in 2008, the IRA contribution limit for such people will be $6,000 for individuals ($12,000 for couples), while the 401(k) contribution limit for those 50 and older will be $20,000. 

After 2010, when all of the provisions in the 2001 package are slated to expire, the income and contribution limits are supposed to fall back to the levels dictated by the laws in place in 2001.  Few observers believe that this will be permitted to occur.  It is widely anticipated that the increases in contribution limits will be extended.

End Notes:

[1] See Martin Vaughan, “Thomas Details Vision for Developing Broad Retirement Bill,” CongressDaily, May 13, 2005; Jonathan Weisman and Jeffrey H. Birnbaum, “Bush Ally in House Alters Social Security Debate Strategy,” Washington Post, May 5, 2005; and transcript of news conference in FDCH Political Transcripts, April 29, 2005.

[2] William Gale and Peter Orszag, “An Unwise Deal:  Why Eliminating the Income Limit on Roth IRAs Is Too Steep a Price to Pay for a Refundable Savers Credit,” Center on Budget and Policy Priorities, June 4, 2004.

[3] Gale and Orszag, op. cit.

[4] Robert Carroll, “IRAs and the Tax Reform Act of 1997,” Office of Tax Analysis, Department of Treasury, January, 2000.

[5] Robert Carroll, op. cit.; David Joulfaian and David Richardson, “Who Takes Advantage of Tax-Deferred Savings Programs?  Evidence from Federal Income Tax Data,” Office of Tax Analysis, Department of Treasury, 2001; Congressional Budget Office, “Utilization of Tax Incentives for Retirement Saving,” August 2003; General Accounting Office, “Private Pensions:  Issues of Coverage and Increasing Contribution Limits for Defined Contribution Plans,” GAO-01-846, September 2001; and Craig Copeland, “IRA Assets and Characteristics of IRA Owners,” EBRI Notes, December 2002.

[6] Congressional Budget Office, “Utilization of Tax Incentives for Retirement Savings,” August 2003.

[7] Peter R. Orszag, “Improving Retirement Security,” Testimony before the House Ways and Means Committee, May 19, 2005.

[8] Jane G. Gravelle, Congressional Research Service, “Effects of LSAs/RSAs Proposal on the Economy and the Budget,” January 6, 2004.

[9] The tax benefits associated with tax-advantaged saving accounts are a function of an individual’s marginal income tax rate.  A moderate-income individual in the 10 percent or 15 percent tax bracket, for instance, would receive a tax reduction of $10 to $15 for a $100 contribution to a retirement account.  For a high-income individual facing the top 35 percent income tax rate, the same $100 contribution would reduce his or her taxes by $35.  Low-income individuals who owe no income tax receive no tax benefit from these deductions.

[10] Peter Orszag, “Progressivity and Saving:  Fixing the Nation’s Upside-Down Incentives for Saving,” Testimony before the House Committee on Education and Workforce, February 25, 2004.

[11] Jason Furman, “Evaluating Alternative Social Security Reforms,” Testimony Before the House Committee on Ways and Means, May 12, 2005.

[12] Orszag, “Progressivity and Saving.”

[13] These and other proposals are presented in detail by the Retirement Security Project;