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How Much Do 401(k)s Cost the Treasury?


Alicia Munnell, the director of the Center for Retirement Research at Boston College, is a weekly contributor to “Encore.

Contributions to 401(k) plans are treated favorably under the federal personal income tax. The government does not tax either the employee or employer contributions to these plans or the investment earnings on the contributions until the monies are withdrawn in retirement. In addition, deferral shifts income to a time of life when people have less income and thereby face a lower tax rate. This treatment significantly reduces the lifetime income taxes of those employees who receive part of their compensation in contributions to a 401(k) compared to those who receive all their money in cash wages.

This favorable treatment costs the Treasury money. Precisely how much it costs has become a hotly debated topic given the enthusiasm, in the face of large and rising deficits, for increasing revenues by cutting tax expenditures.

Historically, the federal government estimated the revenue loss on a cash basis. Under this concept, the loss is the net of two figures: 1) the revenue that would be gained from the current taxation of annual contributions and investment earnings in, say, 2010, and the amount that would be lost in 2010 from not taxing benefits in retirement, as is done currently.

While the cash flow approach is meaningful for permanent deductions and exclusions, it does not properly account for deferrals. Consider the case where annual contributions to a plan and investment earnings exactly equal withdrawals during that year. Under cash flow accounting, the revenue loss would equal zero. Yet, individuals covered by these plans enjoy the advantage of deferring taxes on contributions and investment earnings until after retirement. The problem is not that cash flow calculations overstate or understate the revenue loss; the problem is that they do not measure the benefit of deferral.

The correct way to estimate the true economic cost of the tax provisions associated with 401(k)s and similar defined contribution plans –referred to below simply as 401(k) plans – is the present value of the revenue foregone, net of the present value of future tax payments, of activities undertaken in a given year. Unfortunately, the present value estimates range from $134 billion (Table 17-4, “Tax Expenditures,” Analytic Perspectives, Budget of the United States) to $27 billion (“Retirement Savings and Tax Expenditure Estimates,” American Society of Pension Professionals & Actuaries (ASPPA), May 2011).

What’s a reasonable number? Our estimate, which will be discussed in next week’s blog post, is between $50 and $70 billion. Why then is the ASPPA number so low and the Budget number so high?

The ASPPA estimate is so low because the authors assume that contributions in 2010 amounted to $110 billion. However, data for 2009 from the Department of Labor Form 5500 show employer contributions of $110 billion and employee contributions of $172 billion for a total of $283 billion. So the ASPPA estimate is based on less than 40 percent of the total contributions to defined contribution plans.

The Budget number is so high for two reasons. First, it is based on IRS Statistics of Income data, which suggest 401(k) contributions 30 percent larger than the Department of Labor Form 5500. Second, the Budget calculation assumes that all 401(k) money is invested in bonds. Therefore, if the money were not in a 401(k) account – the counterfactual – it would be taxed annually at the full rate. In fact, two thirds of 401(k) assets are invested in equities where gains are taxed only when realized and both dividends and gains are taxed at a preferential rate of at most 15 percent.

In short, the ASPPA number is simply incorrect because it is based on only 40 percent of contributions. The Budget number is too high because of unrealistic assumptions. The preferences accorded 401(k) plans probably amount to between $50 and $70 billion each year, still a non-trivial sum.


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    • Gerry C,

      “Tax Exempt government employee retirement packages”?! What pray tell are you talking about?

      “‘Top earners’ can’t invest in tax-deferred savings accounts”? Have you told that to Mitt Romney? Are you unaware that the income cap on eligibility to contribute to a Roth IRA went away in 2010. People can and do convert 401(k)s, which have much higher annual contribution limitations, to IRAs, which some do to avoid RMDs.

    • Most of these comments have missed the point of this article. There is significant lobbying going on right now to cut back or eliminate all tax breaks to qualified retirement plans because they cost the government too much money. This author is trying to point out why that thinking is wrong.

    • Statistics don’t lie, just Statisticians. As someone already touched on is the 10% penalty. There are numerous articles from IRS trying to encourage savings through tax incentives for lower paid tax-payers and trying to get workers to roll over investments. I think the author needs to review the actual data on 1099-R early withdrawals that not only generate taxable income each year, but also a 10% increase in normative taxes.

    • Hey DCDoc, don’t you know “top earners” can’t invest in tax-deffered savings accounts. I don’t know what the limit will be this year but it used to be at $65K the IRA deduction and 401k exemptions start pahing out. And I have no idea where people are comming up with their idea of having a million dollar IRA. From the ’70s when IRAs started the max contribution was $1,000 per year, in the the ’80s it was switched to $2,500, then in the late ’90s and early ’00s it was moved up to the present $6,000. Few people who make less that the maximum income allowable to get into an IRA, could afford to put 20-30% of their income aside. 401Ks which started in the ’90s only allowed 15% with company matches about 5$. These too were also income limited Bush made it 50% and raised the limit. Real investment returns relative to real infation, not the governments bogus “core rate” has been near zero for a couple of decades. In the ’70s people thought that they could retire for 20 year (starting at 65 and living to be 85) on a #hundred grand. Now tha won’t cover 3 years, and at the present rate of rising cost of living a million wouldn’t last more than a few years, especially if you are force to live in an old age home. (average cost $30,000 per month, today, and probable $60,000 a month in 5 years.)

About Encore

  • Encore examines the changing nature of retirement, from new rules and guidelines for financial security to the shifting identities and priorities of today’s retirees. The blog also explores news that affects retirement, from the Wall Street Journal Digital Network and around the web. Lead bloggers are reporter Catey Hill and senior editor Jeremy Olshan. Other contributors include The Wall Street Journal’s retirement columnists Glenn Ruffenach and Anne Tergesen; the Director for the Center for Retirement Research at Boston College, Alicia Munnell; and the Director of Research for Pinnacle Advisory Group, Michael Kitces, CFP.