401(k)s become targets in deficit reduction

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The budget challenges confronting the federal government are leading to scrutiny of tax-advantaged savings accounts such as 401(k)s because they're among the costliest tax breaks -- and top earners may pay the price.

The shift from pension plans, which typically guarantee income for life, to tax-deferred 401(k)s has put more responsibility on savers to ensure they don't run out of money in retirement. As the accounts have grown -- Americans held $3.5 trillion in 401(k)s as of September --they've become a target in deficit-reduction talks because contributions usually are invested and compound on a pretax basis.

A Brookings Institution report scheduled for release Tuesday will add to research that recommends curtailing the benefits for top earners to boost U.S. coffers.

"We really need to think hard about whether the dollars we are spending are effective at achieving the goals," said Karen Dynan, co-director of the economic studies program at Washington-based Brookings and author of the report. "Our existing programs are falling short."

The benefits reward higher earners who would save anyway while not providing enough incentive for low and middle-income earners, according to Ms. Dynan.

Individual retirement accounts, which many workers roll their 401(k) savings into when changing jobs or retiring, also benefit from tax deferral. IRAs held $5.3 trillion in assets at the end of the third quarter of 2012, according to the Investment Company Institute, the mutual fund industry trade group.

The tax benefit for 401(k)-type plans is the government's third-largest tax expenditure, behind only the mortgage interest deduction and exclusion of employer contributions for medical insurance. It is estimated to cost about $429 billion in forgone revenue from 2013 through 2017, according to the administration's latest budget proposal. IRAs will cost about $100 billion over the five-year period.

Congress faces a series of fiscal deadlines this year, the first on March 1 when automatic federal budget cuts are set to begin. Democrats and President Barack Obama have said they want to increase revenue by curtailing tax breaks. While Republicans have said they won't accept more tax increases, both political parties have called for simplifying the deductions, credits and benefits in the U.S. tax code.

Jack Lew, Obama's nominee for Treasury secretary, said during a confirmation hearing Feb. 13 that improvements can be made to 401(k) plans. "They've worked better for people at the higher end of the income scale than people in the low-to-middle end," Mr. Lew said.

The current incentives encourage wealthy households to shift money into tax-deferred accounts rather than taxable ones, generally without increasing their savings rate, Ms. Dynan said in an interview. Low-income households most at risk of outliving their savings don't receive as much of a benefit because they're taxed at lower rates, she said.

To improve the system, the government should expand tax breaks so more small businesses set up retirement plans for their workers, revamp savings credits for low-income workers, expand access by establishing an automatic IRA program and cap the value of tax deferral in retirement accounts at the 28 percent bracket, Ms. Dynan said.

The limit on the tax benefit for high earners would reduce the budget deficit by about $7.5 billion in the first year, while all of the proposed changes would mean a net reduction of about $4 billion, according to the study.

Ms. Dynan's proposal is part of a budget report being released by the Hamilton Project at Brookings today. The project's director is Michael Greenstone, a professor of economics at the Massachusetts Institute of Technology and the adminstration's former chief economist for the Council of Economic Advisers.

A 28 percent cap means those in the top bracket would pay an 11.6 percent tax on their contributions up front and then 39.6 percent in income taxes when they take the money out, said Peter Brady, senior economist at the Washington-based ICI. Top earners invested in a stock fund returning 6 percent a year would have to hold the investment for 16 years to overcome the penalty, according to Mr. Brady's analysis. "Some people in the top brackets will decide they are better off taking the money and putting it in a taxable account," he said. That would result in fewer employers offering 401(k) plans as they decide it is no longer cost-effective, Mr. Brady said.

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