Tax breaks designed to encourage people to save for retirement will cost the federal government approximately $600 billion over the next five years. Critics note that these expensive programs benefit only the wealthy. How can we get the poor to save for their golden years?
Through automatic savings. Economists and policy wonks have floated lots of proposals to encourage low-wage earners to save what little money they can spare for retirement. Among the cheapest and most popular solutions is automatic savings. New employees, especially the financially inexperienced, are often paralyzed by the myriad investment options in a retirement plan. They also have a hard time envisioning their financial needs 20 or 30 years in the future. Behavioral economists note that people favor inaction in such situations, even if it's irrational. Under the current system, inaction means failure to save. By simply switching the default—requiring people to opt out of a savings program, rather than asking them to opt in—the savings rate could shift significantly.
Other changes would have to accompany the automatic savings program. About one-half of American employees work for a company that doesn't offer a 401(k) program, so the government would have to broaden access to retirement accounts. Some economists have advocated setting up a government-run 401(k) system [PDF] so that every worker could start an account. Others, such as J. Mark Iwry of Brookings and David John of the Heritage Foundation, favor an expanded private program. They argue that the existing 401(k) system is simply too burdensome for small businesses. Under their plan, employers would only need to select from a menu of management companies on a government website, and the outside contractor would establish and administer an IRA plan for employees.
The existing tax treatment of retirement savings is also flawed. Eighty percent of the benefits go to the top 20 percent of earners, who would likely save for retirement even without a tax break. That means the government is spending a lot of money without changing anyone's behavior.
Part of the problem is that the 401(k) program allows a worker to exclude retirement contributions from his taxable income. Because the deductions come off the top—for example reducing his income from $200,000 to $185,000—those dollars would have been taxed at the highest marginal rate that applies to him. Therefore, people in higher marginal tax brackets see more benefit from the deduction than low-wage earners. Some policy makers propose to remedy this by switching the deduction to a tax credit, which delinks the value of the benefit from a worker's tax bracket. For every $1 stashed in a retirement account, for example, a taxpayer would owe 30 cents less in taxes. But that fix would still be incomplete. Very low wage earners pay no taxes, so a credit against their tax bill is worthless. (This is the problem that undermines the existing "Saver's Credit" program, which offers a tax credit of up to $1,000 for lower-income individuals.)
Some have advocated making a retirement-savings tax credit refundable, which means that if the value of the credit exceeds the worker's tax bill, the government would actually deliver a check for the difference. In effect, the working poor could pay a negative tax.
A few think the only way to really pump up savings among the poor is to offer a matching program, similar to the way some companies match employee contributions to 401(k) accounts. Uncle Sam would pitch in $2 for every $1 a low-wage earner contributes, and he would match middle-class contributions dollar-for-dollar. The rich would be on their own.
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Explainer thanks David John of the Heritage Foundation and Roberton Williams of the Tax Policy Center.