In a recent research brief, two economists made a bold proposal to abolish 401(k) plans and individual retirement accounts (IRAs), arguing that the pre-tax defined contribution plans favor the wealthy. Plans with pre-tax benefits are only available to certain employees at companies who offer them, excluding a large portion of the workforce.
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Who benefits from 401(k)s today?
401(k) plans and IRAs were designed to help Americans save for retirement by offering tax advantages. However, critics argue that these benefits primarily favor the wealthy. According to Federal Reserve data, households in the top 10% by income held a median retirement account balance of $559,000 in 2022, while middle-income households lag behind with a median balance of just $39,000, highlighting the massive disparity in household retirement savings.
The tax structure of 401(k) plans allows individuals to contribute pre-tax income, reducing their taxable income in the present. They only pay taxes on withdrawals during retirement, theoretically at a lower tax rate. This setup incentivizes saving but predominantly benefits higher-income earners who can afford to contribute more.
All employees are also not created equal under defined contribution plans. Employers have to participate in the plan in order for employees to do so as well, meaning if an employer does not offer a 401(k), then an employee might not have access to one.
The argument against 401(k)s
Alicia Munnell and Andrew Biggs, the economists behind the controversial proposal, argue that the current system fails to increase overall retirement savings significantly. They suggest that the almost $200 billion lost in tax revenue annually due to pre-tax contributions could be better utilized to bolster the Social Security program, which faces funding challenges.
Their proposal challenges the notion that tax subsidies for retirement savings effectively encourage Americans to save for retirement. Despite decades of these incentives, participation rates in employer-sponsored retirement plans have seen only marginal increases.
Economic recessions and other crises often see employees pull back on their retirement plan contributions. Other stressors, like the difficulty of saving to own a home or even affording day-to-day expenses, can easily put retirement savings on the back burner.
The argument for 401(k)s
Opponents of Munnell and Biggs' proposal raise concerns about the potential negative impact of eliminating 401(k) plans. Many argue that these plans serve as vital retirement savings vehicles for millions of Americans, particularly middle-class workers.
Employers often use 401(k) plans as recruitment tools, offering them as part of competitive benefits packages. Without the tax benefits associated with these plans, employers might be less inclined to provide retirement savings options, leaving workers at a disadvantage.
Moreover, the financial services industry emphasizes the role of 401(k) plans in providing retirement security to lower- and middle-income individuals. Additionally, for many, 401(k)s are the only source of retirement savings, so getting rid of the plan altogether could put an additional strain on Social Security that it might not be able to handle. Stripping away tax advantages could dissuade employers from offering these plans, exacerbating the retirement savings crisis.
The debate over the future of 401(k) plans underscores the complexity of retirement savings policies in the U.S. While some economists advocate for radical reforms to address inequities in the current system, others warn against jeopardizing a crucial source of retirement security for millions of Americans. Regardless of where you stand, one thing is clear — there is considerable inequality in the access to affordable and universal retirement savings options for employees of all levels.
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