Saving for retirement is one of the biggest financial challenges most working families will face. People are living longer, which means more years of retirement to pay for. Costs for healthcare and long-term care remain high. Meanwhile, incomes are being squeezed by higher inflation and rising costs for housing, college, and other major life expenses. These burdens fall particularly hard on the middle class, which is not well-served by many of our retirement savings structures in the United States.
A new report from the National Institute on Retirement Security details the retirement savings challenges faced by the middle class, and how the current structure of retirement tax incentives fails to overcome these challenges. The current tax incentives for retirement savings are oriented around the defined contribution savings system, especially employer-provided 401(k) plans and Individual Retirement Accounts (IRAs). A closer examination reveals that these tax breaks offer little real incentive to save for middle-class families.
The immediate tax benefit of saving in a 401(k) or IRA derives from the immediate tax savings resulting from pre-tax contributions. One can think of this “tax match” as an illiquidity premium for locking-up money for decades to spend later in retirement. However, most middle-class families will only receive a tax match of zero, 10, or 12 percent due to their earnings levels and recent changes to the tax code. That is not a very strong incentive to save, especially with more pressing, near-term financial needs.
Higher income households have a much stronger incentive to save because they face higher marginal tax rates. In fact, households in the top ten percent of the income distribution account for more than half of the present value of tax breaks for 401(k)s and IRAs.
A big part of this distribution comes from the fact that higher paid workers are more likely to be offered a retirement plan. More than 60 percent of families in the top 10 percent receive tax benefits for saving in a traditional 401(k)-style plan, whereas for families between the 40th and 50th percentiles, it is just over 20 percent.
Another challenge facing middle-class families is that while Social Security does much to reduce elder poverty, its income replacement rates drop off quickly, meaning a middle-class family cannot maintain its standard of living in retirement on Social Security alone. With earnings at even half of ‘medium earnings’, the replacement ratio from Social Security is less than 50 percent. This means working families will need another source of income to achieve a secure retirement, likely either a defined benefit pension or private savings.
Many middle-class workers employed in state or local government, by large employers, or who are members of a union still have access to a defined benefit pension. While the tax breaks for defined benefit plans also have an upward skew, DB plans are laser-focused on delivering retirement income and are much more difficult to use as a tax-advantaged wealth accumulation tool, as DC plans sometimes are. For those workers who still have access to a DB pension, the combination of Social Security and their pension benefit can provide a secure retirement. The problems are much more severe for those without a pension–many of whom are not saving and accessing the tax benefits offered.
At any given time, roughly half of American workers don’t have access to a retirement savings plan through their employer. These workers are much more likely to work part-time, in the service sector, or for a small employer. Not only do they miss out on having a retirement savings vehicle as well as any employer contributions that go with it, but they also are unable to take advantage of the tax breaks offered for retirement savings.
An important point that is often missed is that, in addition to the immediate tax savings, a significant portion of the benefit from saving in tax-advantaged accounts is that the internal buildup of investment earnings is not taxed. For those who start saving early, contribute regularly, and contribute significant amounts, there is a substantial amount of money to be earned through this tax-advantaged investment growth. Unfortunately, the workers who are missing from the retirement savings system mostly miss out on this powerful tool for building a retirement nest egg.
There are solutions that could help the missing middle class, if policymakers focus on the tools that can truly help. For instance, the Saver’s Credit is well targeted to the group that is too often missing out on workplace plans and tax benefits. However, it is under-utilized and generally not at a scale that can be expected to change these basic dynamics.
The Saver’s Credit is a tax break that exists to promote retirement savings among working-class and middle-class families, but its benefit pales in comparison to that of other tax expenditures. The federal government annually spends around $1.2 billion on the Saver’s Credit, compared to $100 billion just on tax breaks for traditional DC plans. The Saver’s Credit is plagued by design flaws that contribute to its underutilization, such as its sharp income cliffs and the fact that it is not refundable. A few adjustments to the design of the Saver’s Credit could greatly increase its utilization and deliver a real boost to the retirement savings of those in the missing middle.
Another idea that is often mentioned is scrapping the deduction-based retirement tax incentives and replacing them with a refundable retirement saving credit that is a fixed percentage for all, regardless of income level. This would mean the incentive to save is no longer tied to marginal tax rates. If there was, say, a 25 percent refundable credit for retirement contributions, then a middle-class family would benefit from that credit in the same way as an upper-income family and would have the same incentive to save.
Middle-class families face enough challenges today. Struggling to save adequately for retirement shouldn’t be another one of them. Congress could help families stuck in the missing middle with some thoughtful and targeted reforms to retirement tax incentives.