Scott Sumner  

401k plans do not "subsidize saving"

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USA Today reports:

Most workers who have access to 401(k) plans will be able to invest up to $18,500 next year, plus an additional $6,000 in catch-up contributions if they are 50 and over.

But lawmakers in Washington have been discussing possibly lowering that limit to as low as $2,400 amid the debate over tax reform. . . .

When Thaler was asked on Twitter whether a $2,400 limit to pretax savings would indicate the government was endorsing that amount as adequate for retirement savings, he said other options, such as a 10% deferral, could offset that.

"No reason to subsidize saving by the rich," Thaler said.

This is a rare issue where I agree with Trump (who opposes the change). Thaler is simply wrong when he claims that 401k plans "subsidize saving". There is no subsidy at all; 100% of the income set aside, plus all interest, dividends and capital gains, is fully taxable after age 70. In fact, the real problem is that non-401k savings is double-taxed. Basic fairness suggests that savers be taxed at the same rate as spenders. Without tax deferred savings plans, the lifetime consumption of savers would be taxed at a higher rate than the lifetime consumption of spenders.There should be no limit at all to contributions to 401k plans, and no requirement that money be withdrawn at age 70.

I would add that it's misleading to suggest that this is a program that favors the rich. Obviously the wealthy save more on average, but I was fully maxing out my contributions when I made in the $50,000 to $100,000 range, and I'd guess there were plenty of other people like me. Indeed there was a time when behavioral economists like Thaler sought to encourage people to use these plans.

The fact that the GOP is even considering cutting the limit back to $2400 speaks volumes about the priorities of the modern GOP. It's the sort of proposal I'd expect from Bernie Sanders.

PS. I can't emphasize enough the need to look past the media's framing of the tax issue. It's not about rich vs. poor, it's about spenders vs. savers. Treat those two groups the same, and then make the system progressive based on lifetime consumption.

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CATEGORIES: Tax Reform , Taxation

COMMENTS (19 to date)
Zubon writes:

Even spenders should want to encourage saving. At high enough volumes, it lowers the interest rates at which spenders can borrow money.

It has been said that you cannot "cut" taxes when you are running a deficit, you can only "shift" taxes to a later time period (younger generation). That seems related. A government that wants to spend now needs to seize the money now, rather than planning to seize it after it grows. Stationary versus roving bandits.

davido writes:

Yes, exactly!

My entire 30 year working life I've made sacrifices to contribute as much to my retirement accounts as I possibly can, regardless of what my income was.

The war on 401k's is a war on savers, which is quite demoralizing for those of us trying to provide for our future retirements and not have to rely on Social Security.

Matthew Waters writes:

What I really don't like about 401k's is that they're employer-based. I don't get this American idea of running so many things through our employer (health insurance, life insurance, 401k, etc.)

There are arguments that IRA fees are actually higher because IRA brokers don't have fiduciary duty while 401k does. That may be true, but there is also a lot of excessive 401k fees. At least with IRA's, an informed customer has a choice.

BC writes:

It's disheartening to see how much political language is corrupted: "subsidize saving" means not penalize saving, "budget cuts" means slow the rate of spending increase, "lose health insurance" means not be mandated to buy insurance. I don't even know what it means to "afford" or "pay for" tax cuts. Orwell was prescient, unfortunately.

I agree that the positions of the GOP and Dems on 401(k)s have been curiously flipped. The GOP says they want to encourage saving and investment. That's one of the reasons for lowering corporate tax rates. They also want to reform entitlements (presumably). Well, the more people have saved for retirement the less dependent they will be on old-age entitlements, making them easier to reform politically. For both of these reasons, the GOP historically has favored *expanded* 401(k)s, IRAs, HSAs, etc. Now that the Dems have become defenders of 401(k)s, the GOP should call their bluff and propose *raising* the contribution limits (and raising IRA contribution limits to match the much higher 401(k) limits).

BC writes:

Thaler seems to have fallen victim to some sort of behavioral anomaly. I thought one of the great achievements of behavioral economics was to automatically enroll workers into 401(k)s. So, we need to nudge workers to choose to save more but prevent them from doing so if the nudge actually works?

Scott Sumner writes:

Everyone, Good comments.

Justin writes:

The 401K still favors the rich because the tax deferral is worth more to those in higher income brackets. Same way the charity and mortgage deductions favor the rich.

BC writes:

@Justin: "charity...deductions favor the rich"

This misconception about charitable deductions is a pet peeve of mine, so I am going to comment about it whenever the topic comes up until I see widely read authors make the same point: The charitable deduction is necessary to avoid *taxing charities*, which are supposed to be tax exempt; it's not a "tax break" for donors. Hence, it favors neither rich nor poor donors.

Consider person A with wage 100/hr and tax rate 35% and B with wage 20/hr and tax rate 15%. Both wish to donate 1 hr of their wages to charity.

(1) With no deduction, A pays 35 in taxes and donates the remaining 65 to charity. B pays 3 in taxes and donates the remaining 17.

(2) With the deduction, A donates 100 and B donates 20.

So, without the deduction, *charities* end up paying taxes at the tax rates of their donors. With the deduction, charities pay no tax, as intended given their tax-exempt status. Charities don't sell products to donors so there are no supply and demand elasticities to determine tax incidence. Donors are free to donate whatever amount they want so, by definition, all of the tax is incident on charities.

I suppose it's possible that some strange behavioral anomaly might "nudge" high income donors, but not low income donors, to donate more if there were no charitable tax deduction. But, since nudges don't actually take away choice, not nudging high income donors to donate more is not really "favoring" the rich.

ZC writes:


As a (relatively) low earner, Scott, I take it you've never considered the value of tax rate arbitrage available to high earners through various tax advantaged retirement savings options. With a solo 401k, profit sharing plan, and cash balance plan, it's possible to put away more in a year tax deferred than you can in a decade with the low limits of an employer based 401k.

The ultimate value of doing that will depend on a host of variables, but not paying tax in the current year at a 39.6% federal marginal rate, then realizing that income in a future year at a lower marginal rate, say 25%, is certainly a valuable benefit.

To your point, I guess it can be debated whether that is a subsidy, or a feature, or a bug, but to say that, "There is no subsidy at all; 100% of the income set aside, plus all interest, dividends and capital gains, is fully taxable after age 70" is to not fully understand the unequal value of the benefit to people at different income levels and that their are additional tax code options out there beyond the simple employer based 401k with it's (relatively) low limits on income deferral.

Justin writes:

First,feel free to delete this post if this is getting off topic if this is getting off topic.

@BC: I still maintain that the charity deduction favors the rich because suppose my goal is to donate $20 to a charity and I can deduct the full donation from my taxes. If My marginal tax rate is 40%, this only costs me $12. If my marginal tax is %20, this costs my $16. Combined with progressive taxes, the charity deduction is essentially a promise by the government to match a certain percent of your charitable contribution, but to provide a higher match to high earners. Or put differently, it allows high earners to buy the same thing at a lower price.

You're point about the charities being taxed a the rate of the donor is interesting, but I don't see how it conflicts with my point. It's also not clear to me how a charity should be taxed. I'd favor removing the tax exempt status.

Jake writes:

The left-wing bias in a statement like that is obvious.

401k gets criticized on inequality grounds, and yet virtually no mainstream economists will speak out against Social Security and Medicare, which are far worse.

Thaomas writes:


The problem with the charitable (or mortgage interest) deductions or other kind of tax favored consumption is that it is a "deduction." I'm in favor of a tax subsidy for charitable deductions (and agnostic on mortgage interest) but the subsidy should be at least equal for all income levels as a partial tax credit would do.

I also partially agree with Scott on the 401K deduction, there should be no limit on contributions and no requirement to withdraw at any given age, but the accumulated amount should
be part of the taxable estate.

Thomas Sewell writes:


I get that the donor likely gets some personal utility from making a donation to charity, but consider also that donations from anyone to many charities also benefit poorer people above and beyond just the tax deductible value of a contribution.

ZC writes:

@Thomas Sewell

That's cute, you think charitable contributions benefit poorer people. Ever look into that claim, for example the charity watch site?

Scott Sumner writes:

Justin, No, the mortgage interest deduction is a true distortion. The 401k simply defers taxes. There is no subsidy at all.

ZC, I agree that the tax system is very unequal, but it's wrong to call 401ks a "benefit", they are not. The real problem is that everyone doesn't have unlimited ability to contribute as much as they like to a 401k. In other words, savings not going into 401ks is double taxed.

The solution is to expand the program for everyone, not cut it back.

Justin writes:

Scott: I never said there was a subsidy. I said that 401k's benefit those in higher income brackets because the tax deferral is worth more to them.

ZC's comment basically explains why. The tax deferral is only revenue neutral if my tax rate in retirement is the same as my current tax rate. But my marginal tax rate in retirement is much lower then it is in my high earning years because my only income is from 401k distributions. High income earners can use the 401k to shift a given dollar into a lower tax bracket. If you think this logic is wrong, please point out the error in the following example:

Suppose I have $18000 before taxes. The high tax bracket pays 50% and the low tax bracket pays 25%. My investment doubles by the time I retire. Assume no capital gains taxes.

Case A: I am in the high tax bracket. Without the 401K, I pay income taxes and invest $9000. My investment grows to $18,000. With the 401k,
I invest $18,000. My investment grows to $36,000. Since my taxable income in retirement comes solely from 401k distributions, I am now in the 25% bracket and keep $27,000.

Case B: I am in the low tax bracket. Without the 401K, I pay income taxes and invest $13,500. My investment grows to $27,000. With the 401k, I invest $18,000 and my investment grows to $36,000. Since my taxable income in retirement comes solely from 401k distributions, and I invested the same amount as the person in Case A, I am still in the 25% bracket, and so I keep $27,000.

So the high earner in Case A received a $9000 benefit from the 401K, while the low earner in Case B received no benefit.

John Thacker writes:
The fact that the GOP is even considering cutting the limit back to $2400 speaks volumes about the priorities of the modern GOP.

The proposal (which has issues for other reasons), is a proposal to limit deductible contributions but even increase Roth 401(k)s. It's basically for budgetary gimmick reasons; with Roths, the government gets the tax money now. That does cause some risk, if one can't credibly trust the government not to tax Roths later. (There's a secondary complaint from people concerned with inequality; by taxing upfront, Roths tax people with supernormal returns compared to the market less and people with subnormal returns more than deductible 401(k)s and IRAs).

I 100% guarantee that no policy has or would be considered that would lower the 401(k) contribution limit without leaving Roth 401(k)s the same or even encouraging them more.

Tim Ozenne writes:

IRAs and such are very much akin to the tax treatment of "deferred compensation," which allows certain "executives" and "celebrities" to put off income to taxation to a time when they expect to face lower rates. Whatever they do to IRAs,
they should also do to ALL deferred compensation agreements. Why would these be treated differently?

Matt Waters writes:

The unquestionable benefit of IRA/401k is avoidance of double-taxation.

The deferral benefits of traditional IRA's versus Roth IRA's can be very large. Here are some good calculations of marginal rates of traditional IRA withdrawals. It assumes IRA withdrawals are only non-SS income.

The actual marginal rate depends on SS income, which has a complex formula.

In their test cases, marginal rates are substantially less than the 25-39.6% that would otherwise be paid. For $20k withdrawals in their married couple case, the tax rate is 0%. For $60k withdrawal, average tax rate is 15%.

Compared to a Roth IRA when your bracket is 33%, the $20k withdrawal saves $6.6k and the $60k withdrawal saves $11k.

Having only Roth IRA's gets the intention of avoiding double-taxation while not *also* giving the benefit of tax deferral. This tax deferral gets around the intention of having progressive brackets in the first place.

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