RETIREMENT RESEARCH February 2012, Number 12-4 WHAT’S THE TAX ADVANTAGE OF 401(K)S? By Alicia H. Munnell, Laura Quinby, and Anthony Webb* Introduction Tax reform is high on the nation’s agenda. While Re- expenditure depends on the tax treatment of capital publicans and Democrats may disagree about the ex- income outside of 401(k)s. The fifth section discusses tent to which tax increases should be part of the defi- the potential impact of proposals to cut back on the cit reduction effort, they generally agree that a broader 401(k) tax expenditure. The final section concludes base and lower rates for the federal income tax would that while some reform proposals may make the promote fairness and boost economic growth. The 401(k) tax expenditure more equitable, policymakers base-broadening discussion inevitably raises the should proceed with caution because the employer- question of cutting back on some “tax expenditures.” based retirement system is the main savings vehicle These expenditures are revenue losses attributable to for American workers. provisions of the tax laws that are designed to support particular activities. Prime examples are the provi- sions designed to encourage retirement savings. Pension History in a Nutshell It seems like a good time to understand the nature of these expenditures, determine how the Tax benefits are clearly not the only reason employers revenue losses are calculated, think about how tax sponsor retirement income plans. At the end of the reform could affect the value of these provisions, and nineteenth century, long before the enactment of the speculate how changes might affect participation federal personal income tax in 1916, a handful of very and contributions in tax-advantaged savings vehicles, large employers, such as governments, railroads, utili- particularly 401(k) plans. ties, universities, and corporations, had put in place The discussion proceeds as follows. The first defined benefit pension plans. They did so because section provides a brief overview of the role of taxes the pension was a valuable tool for managing their in the evolution of employer-sponsored retirement workforce. These plans provided benefits based on plans. The second section describes the tax advantage final pay and years on the job. As a result, the value associated with 401(k) plans. The third section dis- of pension benefits increased rapidly as job tenure cusses the magnitude of the 401(k) tax expenditure. lengthened and motivated employees to stay with the The fourth section highlights how the size of the tax firm. Defined benefit plans also encouraged employ- ees to retire when their productivity began to decline. * Alicia H. Munnell is director of the Center for Retirement Research at Boston College (CRR) and the Peter F. Drucker Pro- fessor in Management Sciences at Boston College’s Carroll School of Management. Laura Quinby is a research associate at the CRR. Anthony Webb is a research economist at the CRR. The authors would like to thank Daniel Halperin, Ithai Lurie, and Stephen Utkus for helpful comments. The Center gratefully acknowledges Advisory Research, Inc., an affiliate of Piper Jaffray & Co., for support of this brief. 2 Center for Retirement Research By the end of the 1920s, employer plans covered pay tax on his earnings and then on the returns from 15 percent of the U.S. private sector workforce. The the portion of those earnings invested.4 The favorable railway industry had extended pension coverage to treatment significantly reduces the lifetime income 80 percent of its workers. Most large banks, utility, taxes of those employees who receive part of their mining, and petroleum companies, as well as a sprin- compensation in contributions to a 401(k) compared kling of manufacturers, also had formal plans. While to those who receive all their earnings in cash wages. the income tax was then in effect and it exempted employer contributions to pension plans, less than 5 The Roth 401(k) percent of Americans were subject to the federal per- sonal levy. Defined benefit plans thus emerged as a Since 2006, employers have had the option of offering way for firms to manage their workforce, not as a way a Roth 401(k). Under this arrangement, initial contri- to pay workers tax-advantaged compensation. butions are not deductible. But investment earnings During and after the Second World War, the accrue tax free and no tax is paid when the money is income tax was extended to a much larger share of withdrawn.5 This arrangement is superior to saving the workforce. And postwar tax rates for the typical outside a plan because no taxes are ever paid on the family were significantly higher than in the initial returns to investments. growth period of defined benefit pensions. So while a number of forces clearly contributed to the rapid ex- pansion of employer plans in the postwar period, the Conventional and Roth 401(k)s Offer increasing advantage of the favorable tax treatment Equivalent Tax Benefits was certainly important.1 With the transition from defined benefit to 401(k) Although the conventional and Roth 401(k)s may plans, which began in the early 1980s, it is much sound quite different, in fact they offer equivalent tax harder to argue that employer-sponsored plans are benefits. Unfortunately, the easiest way to demon- a key personnel management tool to retain skilled strate this point is with equations. Assume that t is the workers and encourage the retirement of older em- individual’s marginal tax rate and r is the annual return ployees whose productivity is less than their wage. on the assets in the 401(k). If an individual contributes Once vested, workers do not forego any benefits $1,000 to a conventional 401(k), then after n years, the when they change employers. Nor do 401(k) plans 401(k) would have grown to $1,000 (1+r)n. When the contain the incentives to retire at specific ages that individual withdraws the accumulated funds, both the employers embed in defined benefit plans. Some original contribution and the accumulated earnings economists contend that 401(k) plans help employers are taxable. Thus, the after-tax value of the 401(k) in attract and retain high-quality workers – those who retirement is $1,000 (1+r)n (1-t). have low discount rates and value saving – rather than Now consider a Roth 401(k). The individual pays 2 directly affect employee productivity. As such, 401(k) tax on the original contribution, so he puts (1-t) $1000 benefits are more broadly shared among a company’s into the account. (Note the original contribution in workforce, as they go to short- as well as long-tenured this example is smaller than for the conventional workers. But, overall, the contribution of an employer 401(k).) After n years, these after-tax proceeds would plan to personnel management is somewhat less im- have grown to (1-t) $1,000 (1+r)n. Since the pro- portant today than it was in the past. The tax prefer- ceeds are not subject to any further tax, the after-tax ences afforded pensions, as a result, have become a amounts under the Roth and conventional plans are more important aspect of employer-sponsored 401(k) identical:6 plans. Conventional Roth The Tax Advantage $1,000 (1+r)n (1-t) = (1-t) $1,000 (1+r)n Of course, the preceding exercise assumes that Retirement saving conducted through 401(k) plans is the tax rate that people face in retirement is the same tax advantaged because the government taxes neither as that when they are young. If their tax rates decline the original contributions nor the investment returns after retirement when they withdraw the funds, then on those contributions until they are withdrawn as they will pay less tax and have more after-tax income benefits at retirement.3 If the saving were done out- with the conventional 401(k) than with the Roth. If side a plan, the individual would first be required to tax rates rise in the future to cover the deficits in Issue in Brief 3 the budget forecasts, then today’s workers will face overstate or understate the revenue loss; the problem higher taxes in retirement and will have more after-tax is that they do not measure the cost of deferral to the income with a Roth 401(k) plan than with a conven- Treasury. tional one.7 But for most people, changes in tax rates The correct way to estimate the true economic cost before and after retirement are not that significant, so of the tax provisions associated with 401(k) plans is the tax treatment of the two types of 401(k) plans can the present value of the revenue foregone, net of the be viewed as equivalent.8 present value of future tax payments, with respect to contributions made in a given year. Unfortunately, the present value estimates for 2010 range from $134 How Much Does the Tax billion in the 2012 Budget of the United States to $27 billion in a recent study by the American Society of Advantage Cost the Treasury? Pension Professionals & Actuaries (ASPPA). Why is the ASPPA number so low and the 2012 This favorable treatment accorded 401(k) plans costs Budget number so high? The ASPPA estimate is so the Treasury money. Precisely how much it costs has low because the authors assume that contributions become a hotly debated topic given the enthusiasm, in 2010 amounted to $110 billion. However, data for in the face of large and rising deficits, for increasing 2009 from the Department of Labor Form 5500 show revenues by cutting tax expenditures.