Introduction: A recent GAO study found that most retirees and workers approaching retirement have limited financial resources. Many people start their careers with substantial student debt and for a variety of reasons overspend and fail to save enough for retirement.
Part of the disparity in retirement savings stems from lack of access to firm-sponsored 401(k) plans, which allow for much greater retirement saving than IRAs. Part of the shortfall in retirement savings stems from the common practice of workers spending savings in retirement plans prior to retirement.
The most effective way to reduce disparities in retirement wealth is to expand and improve Individual Retirement Accounts. The approach outlined here differs sharply from the proposals in Secure Act 2.0, which favor expansion of 401(k) plans. The proposed improvements to IRAs include a new tax credit, a mechanism for simultaneous contributions to traditional and Roth IRA accounts, increases in the allowable annual contribution, and alterations in rules governing distributions prior to age 59 ½. Specific policy changes that should be implemented include:
- A tax credit for contributions of 20 percent of contributions to an IRA.
- Allow employers to make employer contributions to IRAs instead of a 401(K) plan.
- A new rule allocating part of the IRA contribution to a traditional IRA and part to a Roth IRA. (Eighty percent of employee contributions would go to the Roth account. Twenty percent of employee contributions and all employer contributions would be allocated to the traditional account.)
- Prohibit all disbursements from the traditional account until the account holder reaches retirement age.
- Increase the allowable annual contribution to an IRA to the current contribution limit for 401(k) plans.
- Allow automatic contributions to IRAs and opt-out rules like the automatic enrollment and opt-out rules currently applied to 401(k) plans.
Comment One: The use of a tax credit instead of a tax deduction favors low-income households with lower marginal tax rates. These household often have the most difficulty saving for retirement.
Comment Two: The new IRA contribution rules allow for the benefits of both Roth and traditional accounts. The contribution to the Roth account reduces taxes in retirement. The contribution to the traditional account reduces current-year taxes. The plan described here would provide benefits comparable to benefits received from a Roth 401(k) where the employer match is allocated to a traditional 401(K) and employee contributions are allocated to the Roth component of the plan. Many firms do not offer a 401(K) plan, do not offer a Roth 401(k), or do not match employer contributions. The new rules would allow all workers to allocate funds to both traditional and Roth plans, regardless of what their firm offers.
Comment Three: Current tax law allows for unlimited disbursements from retirement accounts subject to tax and penalty. The rules governing penalty and tax on disbursements differ for traditional and Roth accounts, however, in both cases taxpayers are allowed to withdraw the entire balance of their retirement account prior to retirement. This often happens when workers leave a job and take a disbursement rather than maintain their retirement account or roll over funds into an IRA. The new rule requires the amount of the IRA contribution equal to the tax credit and the amount of the contribution received from the employer remain in a traditional account until age 59 ½. Call this the George Bailey rule after the banker in A Wonderful Life who refused to close people’s accounts during a rush on the bank.
Comment Four: Some people may be more receptive to contributing to a 401(k) plan instead of an IRA because some firms allow 401(K) owners to borrow from the plan. Loans from IRAs are not allowed. However, contributions to a Roth IRA can be withdrawn without penalty or tax at any time. The combination of a tax credit and early use of funds contributed to ithe Roth component of the new IRA should facilitate contributions by people with limited cash flow for emergencies.
Comment Five: Current IRA contribution limits are substantially lower than current 401(k) contribution limits. This proposal eliminates this disparity.
Comment Six: The IRS allows firms to automatically enroll employees into the firm-sponsored 401(k) plan and allow employees to opt out if they do not want to contribute. Vanguard has found that automatic enrollment into 401(K) plans has the potential to substantially increase 401(k) participation. Automatic enrollment into IRAs could have a similar effect, especially when combined with a new tax credit for IRA contributions and other proposed enhancements to IRAs.
Comment Seven: Congress is currently considering the Secure Act 2.0, which would expand the use of 401() plans and create an incentive for 401(k) contributions for people who are currently prioritizing student debt repayment over retirement saving. Even if the Secure Act 2.0 is enacted many small firms would still not offer a 401(k) plan, due to limited resources. For example, the Secure Act 2.0 would do little to increase retirement savings for people working at multiple part-time jobs. The tax credit for IRA contributions described here would be available for all workers. The new rules governing early distributions from IRAs would better balance the need for all workers to save for retirement while reducing debt and preparing for emergencies.
Authors Note: David Bernstein, a retired economist has written several papers advocating for innovative centrist policy solutions.
The kindle book Defying Magnets: Centrist Policies in a Polarized World has essays on policies student debt, retirement savings and health care.
The paper A 2024 Health Care Proposal provides solutions to health care problems that are not currently under consideration.
The proposals in Alternatives to the Biden Student Debt Plan are less expensive to taxpayers than the Biden student loan proposals. The reforms presented here provide better incentives and reductions for future students while the Biden debt-relief proposal offers a one-time improvement for current debtors.