Tax-Favored Retirement Plans

This year, Congress will consider what may be the biggest tax bill in decades. This is one of a series of briefs the Tax Policy Center has prepared to help people follow the debate. Each focuses on a key tax policy issue that Congress and the Trump administration may address.

There are several types of tax-favored retirement plans. They differ mainly on the type of sponsor and the tax treatment of contributions and distributions. Almost all workers are eligible to participate in these plans, but only half actually do. High-income taxpayers participate much more than low-income taxpayers.

Employer-Sponsored Plans (Defined Benefit and Defined Contribution)

Employees often receive retirement benefits from their employers, though participation varies. In 2015, about two-thirds of workers at medium-size and large firms participated in a retirement plan, while only about one-third of workers at small firms enrolled. Most private-employer plans are defined contribution, although some are defined benefit. Almost 90 percent of government employees participated in some form of retirement plan. Most of these are defined-benefit plans.

In general, defined benefit and defined contribution plans are tax-deferred, meaning that neither the employer nor the employee pays tax on the initial contributions or the accumulations. However, employees generally pay tax when they withdraw funds. (The major exception is Roth-type defined-contribution plans, where employees are taxed when they contribute to their accounts rather than when they withdraw funds after retirement. See further discussion below, which compares Roth and traditional plans.)

Defined-Benefit Plans

Some employers, most frequently public ones, offer “defined-benefit” plans, which provide retired employees annuity payments, typically based on their years of work and earnings.

The employer bears the risk of making the annuity payments for the retiree’s lifetime. If retired employees live longer than anticipated, or if the investments financing the employees’ pensions fail to meet expectations, the employer must increase its contributions to make good on the promised benefits. Defined-benefit plans are thus more likely to be offered by large employers, which are better suited to bear these risks and can spread administrative costs across large numbers of participants.

However, the government and the employees themselves also may bear some risk. Defined-benefit plans are insured by the Pension Benefit Guarantee Corporation (PBGC), a federal entity that ensures retired employees receive at least some benefits if their former employers fail to pay the promised sums in full. However, the PBGC’s financial condition is uncertain, and it may not be able to meet its obligations to retirees whose employers do not pay full promised benefits.

Over the past few decades, many private employers have moved away from defined-benefit plans. From 1991 to 2015 the share of full-time employees at medium- and large-size establishments with such plans fell from 59 percent to just 25 percent. Defined-benefit plans, however, still remain the most common type of plan for government employees.

Defined-Contribution Plans

Today, many employers offer defined-contribution plans, which base distributions on the size of combined employee and employer contributions and on the investment returns accumulated on those contributions. These plans include 401(k) plans, 403(b) plans for nonprofit employees, and 457 plans, mostly for state and local government workers. Self-employed workers can create Keoghs, which generally are defined-contribution plans (although they can be defined benefit).

Unlike defined-benefit plans, the owners of defined-contribution plans bear the risk if account assets underperform or if the owners outlive the income their accounts generate. Employees can manage this risk by using plan assets to purchase annuities at retirement.

The share of employees with defined-contribution plans has slowly increased over the past 25 years. From 1991 to 2015, participation of full-time employees at medium-size and large enterprises rose from 48 percent to 56 percent. About half of all workers have defined-contribution accounts.

Individual Retirement Accounts

Broadly speaking, there are two types of tax-favored individual retirement accounts (IRAs): traditional IRAs, which are “front loaded,” and Roth IRAs, which are “back loaded.” With front-loaded accounts, contributions are tax-deductible, but withdrawals are taxed. In back-loaded accounts, contributions are not tax-deductible, but accruals and withdrawals are tax exempt. In both versions, investment returns on account assets (accruals) are untaxed.

Which is a better deal? That mainly depends on the difference between individuals’ tax rates during their working years and during retirement. Individuals who pay higher tax rates while they are working than during retirement benefit more from front-loaded accounts because the original contributions are deducted against higher rates and withdrawals are taxed at lower rates. By contrast, someone who expects to be in a higher tax bracket in retirement would benefit more from a back-loaded account.

However, if tax rates during working years and retirement are the same, front- and back-loaded accounts generate the same after-tax return.

Take, for example, an individual who faces a 25 percent tax rate when making both contributions and withdrawals, makes a before-tax contribution of $2,000, earns 5 percent per year, and withdraws all funds after 10 years.

In a front-loaded account, she would contribute the full $2,000. The account would accumulate interest, and after 10 years the balance would be $3,258. Upon withdrawal, she would pay $814 in taxes, leaving net retirement assets of $2,443. With a back-loaded Roth-type account, she’d pay a 25 percent tax on $2,000 in income, leaving just $1,500 to contribute to her account. With the same 5 percent return, her balance would grow to $2,443. But because she’d owe no taxes on withdrawal, her after-tax proceeds would be the same $2,443.

Table 2 shows what would happen to the same account if the tax rate decreases from 25 percent during working years to 20 percent during retirement. In that case, the front-loaded account would accrue $163 more than the back-loaded version, because lower taxes would be imposed upon withdrawal. Of course, the reverse occurs if the tax rate is higher during retirement than during working years.

Who Uses Tax-Favored Retirement Accounts?

Participation in tax-favored retirement savings accounts varies dramatically with age and income (table 3). In recent years, about one-third of workers under age 30 participated, compared with almost two-thirds of workers ages 45 to 59. Participation also varies by income. About four in five high-income workers participate, but slightly less than one in five low-income workers participate.

401(k) Participation

In recent years, higher-income workers have been more than twice as likely as lower-income workers to participate in 401(k) type plans. And contributions were highly related to income. The average contribution in 2006 was $4,352. But workers earning over $160,000 contributed more than twice the mean ($11,004), while those earning $20,000 to $40,000 put aside just $1,288 on average.

IRA Participation

Participation rates in traditional IRAs also increase with income. However, the relationship between participation and income is less straightforward for Roth IRAs, which limit eligibility to those with adjusted gross incomes under $193,000 (for married workers in 2015).

In addition, because IRA contribution limits are more restrictive than those for 401(k)s, average contributions vary less. In 2014, the average contribution to an IRA was $4,885. Those making $20,000 to $25,000 contributed an average of $2,770, while those earning more than $200,000 put away an average of $5,180. As workers approach retirement, they are given an extra allowance for catch-up contributions, and their average contribution increases.

Among those with traditional IRAs, 45 percent maxed out their contributions in 2014, with a significantly higher proportion of high-income taxpayers hitting the limit. Among those with Roth IRAs, 34 percent contributed the maximum amount, with higher-income taxpayers doing so more frequently. This pattern illustrates one reason why proposals to increase the maximum tax-favored IRA contribution would disproportionately benefit the affluent. By contrast, to shift greater incentives to low- and middle-income households, proposals could expand access to savings vehicles and scale back deductions.

Distribution of Tax Benefit

In aggregate, the tax benefits for retirement savings are large. For 2017, the Tax Policy Center estimates the net present value of retirement savings tax benefits as $187 billion. Retirement tax benefits are among the largest tax expenditures (generally ranked after employer-provided health care benefits).

Retirement benefits are skewed to the upper end of the income distribution, as reflected in table 4. In particular, while only 4.3 percent of the $187 billion in benefits goes to those in the bottom 40 percent, 84.8 percent goes to taxpayers in the top 40 percent. A mere 0.5 percent of the benefit goes to those in the bottom 20 percent.