What if the government abolished your 401(k)? Economists say accounts aren't worth it

The federal government should stop allowing pre-tax contributions to retirement savings, abolishing the 401(k) and Individual Retirement Account, two economists from opposing ideological camps argued in a research brief in January.

Allowing people to shelter their retirement money from taxes is a policy that largely favors the well-heeled, they said. Congress could use that money, nearly $200 billion a year in lost tax dollars, to shore up the underfunded Social Security program.

Their suggestion created a stir. One social media post has drawn more than 700,000 views.

"We do not think that this subsidy, which you can only rationalize if it increases saving ... we don't think it does increase saving very much," said Alicia Munnell, an assistant treasury secretary under President Clinton. She co-wrote the brief with Andrew Biggs, a senior fellow at the right-leaning American Enterprise Institute.

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Why, then, are economists coming after your 401(k)?

That employee retirement plan and its personal savings counterpart, the Individual Retirement Account, were created to help Americans save for retirement.

But federal data suggests tax-favored retirement accounts help only some Americans, and wealthy Americans in particular.

For households in the top 10% by income, the median retirement account held $559,000 in 2022, according to the Survey of Consumer Finances. An overwhelming 93% of those households held retirement plans.

For middle-income Americans, those in the 40th to 60th percentile by income, the median retirement plan held just $39,000, and nearly half of that group had no retirement savings.

Many smaller employers don't offer 401(k) plans. Even when they do, workers might balk at participating, because they can't spare the income or they're afraid they might need to withdraw it later on, triggering tax penalties.

"Income for a lot of workers is very unpredictable," said Monique Morrissey, senior economist at the left-leaning Economic Policy Institute.

A looming crisis in retirement savings

Many researchers believe America faces a crisis in retirement savings. Fewer than half of us have retirement accounts, Census data show. Even among those nearing retirement, ages 56 to 64, the share with retirement accounts lagged below 60% in 2020.

Without a retirement account, most retirees depend on Social Security. But monthly Social Security checks averaged about $1,800 in 2023. The typical household run by someone 65 or older spends $4,345 a month, according to a BlackRock analysis of federal statistics.

The 401(k) and IRA emerged in the 1970s and gained popularity as tools for Americans to build savings for retirement. Over the years, the plans have gradually replaced traditional pensions, which deliver monthly benefits to retired workers. From 1975 to 2019, active private sector pension participants dwindled from 27 million to fewer than 13 million, according to a congressional report.

As investments, tax-advantaged retirement plans are “a really good deal,” said Damon Jones, a University of Chicago economist. The government doesn’t tax income contributed to a traditional 401(k) or IRA. You pay taxes when you withdraw the money in retirement.

The tax breaks cost the federal government about $185 billion a year in lost revenue, according to Treasury Department estimates for 2020.

Yet, millions of Americans don’t take advantage of tax-favored retirement savings − or can't. Nearly half of workers have no access to a retirement plan at work, according to one AARP analysis.

Lower-income Americans miss out on retirement tax breaks

And many lower-income Americans have more pressing priorities.

“Most people, middle-class or lower, struggle to put food on the table and a roof over their head, and they don’t have the money left over to save,” said Steve Rosenthal, a senior fellow in the Urban-Brookings Tax Policy Center.

Wealthier Americans, on the other hand, tend to take full advantage of the tax perks. According to research by the Urban-Brookings Tax Policy Center, three-fifths of the retirement savings tax benefits go to people in the top 20% of Americans by income. More than four-fifths go to people in the top 40%.

“The fundamental problem with our retirement system is it rewards people who need no help,” Rosenthal said. “All the schemes are oriented toward rewarding those who have the savings or the income to reap the benefits.”

The whole point of the tax subsidies was to encourage more Americans to save for retirement, say the authors of the research brief, published by the Center for Retirement Research at Boston College.

But that hasn’t happened. From 1989 to 2022, the share of workers ages 25 to 64 who participate in employer-sponsored retirement plans has risen 2 percentage points, from 51% to 53%, the researchers found.

“They’re basically saying we ought to call it quits on our retirement tax system because it’s broken. And it is broken,” Rosenthal said.

Many in the financial industry applaud tax-favored retirement plans

Agreement on that point is far from unanimous, and some in the retirement industry greeted the new research with vitriol.

Brian Graff, chief executive of the American Retirement Association, flagged the paper on LinkedIn with the comment, "No, it's not April 1st. . . and I personally cannot think of a more preposterous idea."

Much of the financial services industry applauds tax-favored retirement plans, saying they deliver a dignified retirement to millions of lower- and middle-income Americans.

“It’s not only the rich,” said Craig Copeland, director of wealth benefits research at the Employee Benefit Research Institute, a nonprofit that works with benefit providers. “A lot of middle-class people have 401(k)s, and typically, that’s the bulk of their savings outside of their homes.”

Strip away the tax benefits, Copeland says, and employers would lose their incentive to offer retirement savings in the first place. Companies use 401(k) plans to attract workers, and employers reap their own tax savings by administering the plans.

“Most of these plans wouldn’t exist if there wasn’t a tax preference for them,” he said.

Abolishing the tax subsidies “is not going to hurt the wealthy,” Copeland said, “because the wealthy are going to save. It’s going to hit those middle-quartile people” − the middle class.

Even the economists who wrote the brief concede there’s little chance Congress will abolish tax-favored retirement savings anytime soon.

“I know they’re not going to repeal it tomorrow,” Munnell said. “But it should be part of the debate.”

Instead of eliminating the tax benefits, the economists say, Congress could modify the subsidies so the programs reward responsible saving without lavishing tax breaks on the wealthy.

For example, the tax subsidy could be capped for savers who amass $500,000 or $1,000,000 in retirement money. Or, the tax benefit could be limited to the first $10,000 or $20,000 in annual contributions.

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Alternatively, Congress could lower the age by which savers must begin drawing down their retirement accounts. Instead of lowering that age, Congress has been raising it, from 70½ in 2019 to 75 in 2033.

“If you’re troubled by how large these retirement plans are, you can limit what goes in,” Rosenthal said, “or you can limit what comes out.”

Daniel de Visé covers personal finance for USA Today.