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Pensions, tax treatment of

Originally published in the NTA Encyclopedia of Taxation and Tax Policy, Second Edition, edited by Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle. The encyclopedia is available in paperback from the Urban Institute Press. Order online at www.uipress.org or call toll-free 1-877-847-7377

John A. Turner
AARP Public Policy Institute, Washington, D.C.

To encourage saving for retirement, tax policy generally accords favorable treatment toward contributions, investment income, and benefits related to assets accumulated in pension plans for retirement.


Private pensions receive favorable tax treatment in the United States and in all developed countries with well-developed pension systems, though the particularities of the tax treatment differ (Rein and Turner 2004). In the United States, an employer’s pension contribution is deductible in computing corporate income taxes, the investment earnings on plan assets are not taxed, and neither the contribution nor investment earnings are treated as taxable income to the worker at the time those monies are received by the pension plan. The employee is taxed once-personal income tax liability is deferred until the employee receives a distribution from the plan. In comparison, for savings through wage payments, the employee is taxed twice-when wages are received and when investment earnings are received on the subsequent savings.

Policy aspects of the tax treatmentof pension plans

The U.S. tax code requirements to qualify for favorable tax treatment are used to regulate pension plans. To be taxqualified, a plan must meet minimum standards regarding worker participation and vesting, and nondiscrimination against lower-paid workers (McGill et al. 1996). For plans not meeting these standards, the employer’s contribution must be included in the employee’s taxable income if it is to be taxdeductible to the employer.

Favorable tax treatment is justified by the argument that without a tax subsidy, many families would save too little for retirement. A key issue, however, is do the tax exemptions increase pension coverage and individual savings or do they merely substitute pensions for other forms of saving? As well as the possible effect on workers’ savings, the tax treatment of pensions may affect other microeconomic decisions of workers and employers: wages versus pensions, deferred wages versus pensions, other fringe benefits (such as employer-provided health insurance) versus pensions, Social Security versus pensions, defined benefit versus defined contribution plans, individual plans versus employer-provided plans, self-employment versus corporate employment, lump-sum benefits versus annuities, and pension investments in some types of assets versus others.

Calculating the tax liability

Private pension plans involve three transactions that are possible occasions for taxation-contributions, investment earnings and assets, and benefits payments.

Contributions

Because employer pension contributions and wages are both deductible business expenses under the corporate income tax, from a tax perspective employers are indifferent between paying wages and contributing to pension plans. However, they are not indifferent between making pension contributions and paying deferred wages. Because employers cannot shelter money set aside to pay deferred wages from the corporate income tax, employers prefer to defer compensation using pensions instead of deferred wages.

To protect the Treasury against excessive tax deductions, limits are placed on pension contributions. Maximum contributions to a pension plan depend on plan type (e.g., defined benefit, profit sharing), whether the employee is covered by more than one plan, and whether the plan is top-heavy, which refers to plans (mainly for small firms) where a disproportionate amount of the benefits accrues to the owners of the firm and key employees. Limits are also placed on the maximum employee earnings that can be used to determine benefits or contributions. There are also contribution limits for employers in defined benefit plans based on how far pension assets exceed or fall short of liabilities.

Employer and employee contributions are treated differently by the U.S. tax code. Employer contributions are not taxed as income to the employee, avoiding personal income and Social Security payroll taxation when the contributions are made.

Employee contributions are generally taxable under the personal income tax and the Social Security payroll tax. Employee contributions to salary reduction plans are an exception, being exempt from taxation.

The most common type of salary reduction plan is the 401(k) plan, named after the Internal Revenue Code section enabling it. In salary reduction plans, employee contributions are deductible from before-tax wage earnings, a feature that may explain much of their popularity. Presumably as a result of the disparate tax treatment, while salary reduction plans generally require employee contributions, other pension plans rarely do.

Investment earnings and assets

Once an employer or employee has contributed to a pension plan, the investment earnings on those funds are not taxed. This exemption from tax results in what is called the "inside buildup." Pension assets maintained in the pension plan are also not taxable. However, when an employer terminates an overfunded defined benefit plan and surplus plan assets revert to the employer, those assets are taxed at the corporate income tax rate plus an excise tax of 20 percent. The excise tax rate is increased to 50 percent unless the employer transfers part of the excess assets to a replacement plan or provides a benefit increase under the terminating plan. This tax discourages firms from terminating overfunded defined benefit plans.

Benefits payments

Pension benefits received at retirement or earlier are taxed under the federal and state personal income taxes, but are not subject to the Social Security payroll tax. Participants generally recover tax-free the amounts, if any, that have been included previously in their taxable income. These tax-free amounts are called "basis," and generally consist of the employee’s aftertax contributions to 401(k) plans. Because of the progressivity of the income tax system and the reduced income most people receive in retirement, workers frequently have lower marginal income tax rates in retirement than while working. Lump-sum distributions received before retirement are subject to an excise tax as well as the personal income tax. In addition to income taxes, a tax of 10 percent is levied on lump-sum distributions before age 591/2 unless the worker has separated from service and is at least age 55. The excise tax is designed to discourage those distributions under the theory that pension plan assets should be used exclusively for financing retirement consumption. Retired workers wishing to postpone benefit receipt are required to begin receiving their pension benefits by age 70 1/2 or pay an excise tax of 50 percent on the amount that was required to be distributed. With increases in life expectancy, there has been some discussion of raising this age.

Implications of the tax treatment of pensions

The tax treatment of pensions moves the United States toward a consumption tax system. Earnings saved through a pension are not taxed until received and presumably consumed in retirement. A consumption tax avoids the double taxation of savings that occurs under the current income tax system.

The two aspects of the tax advantage of pensions are income smoothing and the tax-exempt status of pension plan earnings. When income is taxed according to a progressive tax scale, workers can avoid paying high marginal tax rates on pension contributions during their working lives and instead can pay lower inframarginal tax rates when they receive their pension during retirement.

Even if the marginal tax rates the worker paid were the same in retirement as when working, with a progressive tax scale the worker can gain because the first pension dollars are taxed at lower inframarginal rates. The first dollar received in retirement is taxed at the lowest tax rate, and subsequent dollars are taxed at progressively higher marginal rates. Because of the tax advantages of income smoothing, workers will want larger pensions under a progressive tax system than a flat tax system (Ippolito 1990).

Changes in the tax system have reduced the desirability of defined benefit plans relative to defined contribution plans. Since the early 1980s, employees have been able to make taxdeductible contributions to defined contribution (401(k)) plans but not to defined benefit plans. Also, the Omnibus Budget Reconciliation Act of 1987 reduced the amount of funding that could be put into an overfunded pension plan. This reduced the amount that could accumulate in a defined benefit plan earn- ing the tax-free rate of return, reducing the tax advantage of defined benefit plans relative to defined contribution plans.

Pension tax expenditures

Offsetting the advantages provided by the favorable tax treatment of pensions is the loss in tax revenue that results. The tax expenditure figures indicate the amount of federal income tax revenue lost in a tax year as a result of private pensions. Tax expenditures for pensions are measured relative to a comprehensive income tax under which the increase in the present value of expected retirement benefits (roughly equal to the employer contribution plus investment earnings on pension assets) is included in the employee’s taxable income. Pension benefits are not taxed. Thus, the Treasury Department’s estimate of tax expenditures consists of the revenue loss from exempting employer contributions and investment earnings, offset by the revenue gain from currently taxing private pension benefits. Most of the tax benefits of pensions accrue to middle-income families. The tax expenditure for pensions is the largest tax expenditure for individuals.

The tax expenditure figures overstate, however, the longterm loss of revenue. A worker’s lifetime loss measure would calculate the amount of revenue lost this year as a result of pension accruals for workers and subtract the expected present value of taxes paid on those currently accruing benefits. Unlike health insurance premiums, which are never subject to federal taxation, retirement fund contributions and investment earnings eventually face the individual income tax when paid out to retired workers.

ADDITIONAL READINGS

  • Ippolito, Richard A. An Economic Appraisal of Pension Tax Policy in the United States. Homewood, IL: Irwin, 1990.
  • McGill, Dan M., Kyle N. Brown, John J. Haley, and Sylvester J. Schieber. Fundamentals of Private Pensions. 7th ed. Philadelphia: University of Pennsylvania Press, 1996.
  • Rein, Martin, and John Turner. "Pathways to Pension Coverage." In Reforming Pensions in Europe: Evolution of Pension Financing and Sources of Retirement Income, edited by Gerard Hughes and James Stewart (285-300). Cheltenham, UK: Edward Elgar Publishing, 2004.