Category: Retirement

Linking Social Security reform with Private Saving Reform

Increases in the eligibility age for Social Security benefits need to be phased in slowly to prevent financial shocks to households nearing retirement and coupled with new policies that increase savings by younger adults. This post considers how a gradual change in Social Security benefits could be attached to proposals that promote increased private saving.


Introduction:  One approach being considered to expand the lifespan of the Social Security Trust fund involves increases in the eligibility age for receipt of the minimum and full retirement benefit.  This approach would result in substantial improvements in the financial condition of the Trust fund.  It would both increase revenue by forcing people to work longer and would delay outflows from the Trust fund.  It would reduce the future debt to GDP ratio and reduce the likelihood of future increases in taxes to pay off debt.  

However, there are adverse impacts and limitations associated with increases in the eligibility age for Social Security benefits.

First, most current retirees are highly dependent on Social Security.  (A study based on data from the Current Population Survey reveals 52 percent of older households receive more than half of their income from Social Security and a third receive more than 75 percent of income from Social Security.)  Workers currently nearing retirement could not be expected to substantially increase their savings to prepare for the increased retirement age. 

Second, A phased in increase in the retirement age would not prevent project automatic reductions in Social Security benefits associated with reduced Trust fund reserves.

Third, many workers when they near the eligibility age for Social Security benefits need to retire or need to reduce the hours, they work because of health concerns.  Health related problems impacting older workers will impact both current workers nearing retirement and future cohorts of workers. 

Fourth, younger adults are having an extremely hard time saving for retirement.  Student debt is at a record level and continues to climb with college cost and many young adults with high student debt burdens are either delaying saving for retirement or disbursing funds in retirement accounts early in their careers to meet current obligations.  A discussion of the use of pre-retirement funds prior to retirement can be found here.  In addition, young workers must save more for retirement than previous retirees because they are less likely to have access to a traditional defined benefit pension plan.

Changes to Social Security retirement benefit formulas need to be implemented gradually to avoid an abrupt economic shock impacting people nearing retirement and need to be linked with changes in savings incentives and economic reforms which facilitate increased private savings for retirement.

Increasing the eligibility age for Social Security Benefits:  Under current law, workers initially become eligible to claim Social Security retirement benefits at age 62.  People born after 1960 are eligible for the full Social Security retirement benefit at age 67.  The largest possible Social Security benefit is received by people who delay claiming until 70.

Changes to three parameters – the initial eligibility age for Social Security benefits, the eligibility age for the full benefit, and the age where people receive the maximum allowable benefit – are considered here.  The proposed changes would start five years after enactment after legislation.  The three retirement age parameters would increase by one month every two years until all three retirement ages increased by two years.  After the full enactment of the increased retirement age, the minimum eligibility age would be 64, the age of full benefits would be 69 and the age of the maximum benefit would be 72.

When the Social Security eligibility age is phased in many recipients will receive two fewer years of benefits over their lifetime.  

The phased in benefit reductions put the United States on a more favorable and sounder fiscal trajectory. These benefit reductions will reduce the future debt to GDP ratio.  However, the phased in adjustments do not prevent the automatic reductions in Social Security, which are current projected to occur in 2034.  The prevention of the automatic benefit cuts requires some other action by Congress.

One approach to deal with the automatic benefit cuts would involve the use of general tax revenue, which would lead to higher annual budgets. The projected future debt to GDP ratio is a more important measure of fiscal health than annual budget deficits because markets are forward looking, hence the prospect of lower future debt levels will restrain interest rates even if deficits rise in the short term.

The avoidance of projected automatic cuts to Social Security will also require some additional revenue from an increase in the payroll tax or some other tax.

The phase in of these changes would have to be slow to avoid financial shocks on people nearing retirement and to allow for increased private savings. The slow phase of the benefit changes allows for people to increase retirement savings prior to retirement. Younger adults will experience the full brunt of the change in the Social Security eligibility change but will also have more time to take advantage of reforms that will facilitate increased private savings.

Facilitating increased private savings:  Since most households nearing retirement age will be highly dependent on Social Security and most younger households have either delayed or reduced saving for retirement to meet current needs the proposed increase in the eligibility age for Social Security benefits must be accompanied by policies that lead to increased savings for retirement. 

The first set of policy proposals involves direct improvements to savings incentives and investment vehicles offered by investment firms.  The proposed changes in tax incentives and financial rules favor households which are currently having a difficult time saving for retirement, including people without access to the most generous employer-sponsored and people reducing retirement savings because of medical expenses.  The new tax and financial rules will provide incentives for workers to start saving for retirement at a younger age.

 Modifications to Direct Savings Incentives and Rules:

Tax and pension rules should be changed to equalize savings opportunities for workers dependent IRAs and 401(k) plans. 

  • Currently, higher income taxpayers will receive a higher tax savings from a 401(k) contribution than a low-income taxpayer.  This disparity would be eliminated by replacing the tax credit for contributions to retirement plans with a tax credit.
  • Current tax law allows employers to match employee contributions to 401(k) plans but does not allow for matching contributions to IRAs.  The rules should be changed to allow employers to contribute match employee contributions to IRAs as well as to 401(k) plans.
  • Tax law could be changed to allow firms to provide tax free contributions to retirement accounts of gig employees.  
  • Current limits on employee contributions to IRAs are lower than contributions to 401(k) plans.  These contribution limits should be equalized.

Improve the automatic 401(k) enrollment option and create a similar automatic savings option for firms that do not offer a 401(k) plan.  

  • The newly enacted automatic 401(k) enrollment option allows for firms to automatically enroll workers in 401(K) plans that charge high fees or have few investment opportunities.  The government could improve investment outcomes and increase wealth at retirement by limiting fees and by requiring access to low-cost or zero-cost investment options like direct investments in Treasury securities.
  • Automatic enrollment into IRAs or savings through Series I savings bonds should be created for workers employed at firms without a 401(k) plan.  The new automatic enrollment provision would be patterned after the 401(k) automatic enrollment provision, which allows workers to opt out of the automatic contribution and sets the initial contribution at 3 percent of income.  The expanded automatic enrollment provisions create an incentive for younger adults to either open an IRA or some other savings vehicle.  (Most young workers do not have access to a firm-sponsored retirement plan or are subject to vesting requirements.)   The initiation of saving at a younger age is a crucial reform needed to assure increased wealth at retirement.

Create rules that prevent use of all retirement fund prior to retirement and encourage workers to reduce leakages of funds from retirement accounts.

  • Current tax laws allow for investors to disburse all savings from a 401(k) plan or IRA prior to retirement.  (Disbursement rules are complex and often involve payment of tax and penalty.)  A new rule might prohibit pre-retirement disbursements greater than a certain percent of contributions, perhaps 50 percent of contributions.
  • Many young workers automatically disburse all funds contributed to a retirement plan at their first permanent job.  The default option for 401(k) funds during job transfers should be automatic transfer to a low-fee independent account. The worker who wants to maintain retirement savings at her old employer or withdrawing funds from an existing account would have the option of opting out of default arrangement.

Modify tax rules governing Flexible Savings Accounts (FSAs) and Health Saving Accounts to allow for increased savings.

  • Current rules governing FSAs result in the FSA owner losing any unused funds in the account at the end of the year.  A change in FSA rules that allows unused FSA funds to be rolled over into a 401(k) or an IRA would encourage greater contributions to FSA accounts and increase retirement savings.
  • Current rules only allow people with qualified high deductible health insurance plans to contribute funds to a health savings account. A change in these rules to allow for health savings account contributions for people with a wider variety of accounts could expand savings for health care and for retirement.   The new rule could lower rate of depletion of funds in the health savings account or increase contributions to retirement accounts since health savings accounts are often funded by decreased contributions to retirement accounts.

Expand investment opportunities in 401(k) and 529 college savings plans to allow for direct investment in Treasury securities including Series I Savings bonds and the tax-free conversion of 529 assets to 401(k) plans:

  • Many retirement plans and virtually all College Savings 529 plans allow for investments in a few fixed-income and equity funds and do not allow for workers to purchase bonds with a specific maturity date.   These bond funds, even those with short maturity assets fall in value when interest rates rise.  Investors should be given the option of holding Treasury securities to maturity when they will be guaranteed access to the initial bond purchase and all interest.
  • Rules should require retirement plans to provide access to all Treasury bonds including Series I bonds and Treasury Inflation Protected Securities (TIPs).  Access to these investments would reduce loss of wealth from fees and reduce portfolio risk.  
  • Current law taxes disbursements from 529 plans not used for educational purchases.  Workers should be allowed to convert part of the unused 529 plans to a 401(k or IRA without paying tax.  (Typically, the 529 contribution is exempt for state tax but not exempt from federal tax.  Since the initial contribution to the 529 plan was subject to federal tax the loss of federal tax revenue from this proposal might be modest.) 

Removal of Impediments to Saving for Retirement:

Many people fail to save for retirement because they get caught in a spiral of debt and live paycheck to paycheck for a prolonged period.  Often young adults delay saving for retirement or even raid their retirement plan to maintain their student debt payments. Roughly 9 million borrowers over the age of 50 are still making payments on their federal student loans and are having trouble meeting expenses in retirement.  

Other households, especially people with employer-based health insurance often lose health insurance during job transitions.  A loss of health coverage and increased medical debt exacerbating disruptions in the process of savings for retirement routinely occur during recessions.  

A second set of policy initiatives attempts to remove impediments to saving experienced by people who have high student debt or lose health insurance during job transitions.

Implement policies to reduce student debt burdens to facilitate increased savings for retirement.

  • Many of the most vulnerable student borrowers that have difficulty both repaying their student debt and saving are people who borrow but never complete their degree.  The number of households in this situation could be drastically reduced by the implementation of policies that reduce or eliminate debt by first-year students.  The elimination of first-year student debt would also reduce average student debt burdens for all students with debt.  This proposal is far less expensive than the Sanders program to eliminate all college debt at public universities. 
  • Currently student borrowers must choose between a standard student loan contract and an Income Driven Loan (IDR) program as soon as they start loan repayment. In some instances, people who chose the IDR program paid more on their loan over the lifetime of the loan or failed to get the timely debt discharge as promised.  The standard loan contract does not offer the possibility of a loan discharge even if the borrower has low income in the future.   These problems can be mitigated by a modification of the standard student loan contract to include the elimination of all interest charges combined with accelerated repayment obligations 10 years after the initiation of repayment.

Modify rules governing tax incentives for employer-based health insurance and state exchange health insurance to allow for reduced loss of health insurance during economic downturns

  • The proposed solution to discontinuities in insurance coverage stemming from changes in employment involve – a rule change allowing employer subsidies of state-exchange insurance instead of employer-based insurance, the automatic conversion of employer-based insurance to state exchange insurance when employees are laid off, and a modification of the premium tax credit for state exchange insurance. More information on this proposal and other health care reforms can be found here.

New Political and Economic Dynamics:  The current political debate on Social Security involves proposals to either cut benefits or increase taxes and ignores problems caused by disparities in private retirement savings.

Any change to an inter-generational program must be phased in slowly to avoid political and economic turmoil.

However, most young adults would be unable to substantially increase their savings rate given current savings incentives or high debt burdens.

A higher eligibility age for Social Security benefits must be accompanied by reforms designed to reduce disparities in private savings.  These reforms will reduce the dependence of future generations on the Social Security program.

Many of the improvements in savings incentives, reductions in student debt and improvements to health insurance proposed here, are unaffordable if not accompanied by substantial new revenue or budget cuts.

Increases in retirement savings require changes in retirement plan rules and procedures.  Many current rules favor Wall Street over investors and tie investors into expensive products offering suboptimal returns or high levels of risk.

Social Security reform and private savings reform are intrinsically linked.

The proposals presented here would reduce wealth inequality and will improve the fiscal condition of the nation, truly a rare combination.

The Choice Between Fixed Income Funds and Direct Purchases of Bonds

Whenever possible investors should seek out tax-preferred savings vehicles, which allow for direct investments into Treasury securities and hold Treasury bonds and notes instead of fixed-income funds. People saving for retirement or higher education can minimize risk by matching future obligations with specific bonds.


Introduction:

Many tax-preferred retirement accounts and 529 funds restrict investment choices to a small set of stock and bond ETFs or mutual funds.  The allowable investments inside a 401(k) plan are selected by the plans sponsor. For example, the Thrift Savings Plan (TSP) offered to federal employees has several funds and an option for mutual fund investing but does not allow workers to purchase Treasury Securities directly through the Treasury or through a broker.

Most individual retirement accounts (IRAs) and brokerage accounts allow for direct investments in the stock of individual companies, Treasury securities, agency securities, and corporate bonds.  Individual investors at Fidelity and Vanguard with an IRA account can purchase the same assets as investors with a brokerage account at the firm.

Individuals saving in plans that are not tax preferred can purchase bonds either through a brokerage account or through Treasury Direct.  Series I savings bonds can only be purchased directly from the Treasury and are therefore not available for retirement savers or for people utilizing 529 plans for college savings.

Retirement savers with an IRA can purchase Treasury Inflation Protected Securities (TIPs) through their brokerage company.   Whether this option is available through a 401(k) plan depends on the investment options chosen by the plan’s provider.  Most 401(k) plans that I am aware of do not allow for direct purchases of TIPs. 

Many financial advisors, including one mentioned in this CNBC article, favor the use of bond ETFs over direct purchases of Treasury securities.  The prices of the bond funds touted in this article appear highly variable. 

The use of bond funds instead of direct investments in bonds often results in inferior financial results.  Both bond prices and bond ETF or mutual fund prices vary inversely with interest rates.  The difference in financial exposure stemming from holding a bond and the financial exposure from holding a bond fund is that the bond holder can avoid losses by holding the bond until the maturity while returns for the holder of the bond funds are always dependent on interest rates.

All 401(K) plans have bond fund options. Many 401(k) plans have an option for short-term bonds that primarily invest in inflation protection securities.  However, even short-maturity bond funds designed to protect investors from the eroding effect of inflation can result in substantial financial losses for investors.

The returns for VIPSX are -10.45 % over a one-year holding period and 1.02 percent over a 10-year holding period.  Other short-term bond funds seeking to protect investors from inflation including STPZ and VTIP do not appear to be meeting their objective in the current macroeconomic environment.

There is one sure fire way to insulate your portfolio from inflation, the purchase of Series I bonds.  However, the IRS imposes an annual limit on the purchase of Series I bonds, and Series I bonds cannot be purchased in IRAs, 401(k) plans or 529 plans. Most household with most of their financial portfolio inside a retirement plan cannot purchase enough Series I Savings bonds to insulate themselves from inflation.

The performance of both long-term Treasury bonds and bond funds has also been miserable.  See BND, AGG, and FNBGX and look at the chart with the longest time span of historical prices.

Advantages of Direct Investments in Treasury Securities:

Investors who purchase a Treasury security at a positive yield and hold the Treasury security to maturity will never experience a nominal loss on the security.  

However, many investors will sell a long-term security prior to its maturity.

Investors should not purchase either a long-term bond or a long-term bond fund when interest rates are extremely low, as they were during the pandemic, since at that time interest rates were certain to rise and bond prices certain to fall.

Investors can spread out bond purchases over several months to assure monthly access to liquid retirement assets.  The purchase of six-month Treasury bills on six consecutive months would allow for monthly access to liquid assets.

The price risk of a Treasury security goes towards zero when the security nears its maturity date.  An investor needing funds shortly before the maturity date could sell the asset without a substantial loss, even if interest rates rise. By contrast, short-term bond funds have no maturity date, hence the price of the fund will fall if interest rates rise.

Investors can match the maturity of bonds that they hold with future liabilities.   This is an especially important feature for parents saving for college tuition who could match bond maturities with tuition payment due dates. 

However, 529 plans commonly used for saving for college generally do not have an option allowing for direct investments in Treasury securities.  Instead, the plans allocate investments into bond and stock ETFs or mutual funds.   The price of funds inside college 529 plans, even the short-term bond funds, vary substantially with market conditions.

Both savers in 529 plans and savers in retirement plans often save through a life-cycle fund that shifts assets from stocks to bonds as investors near retirement.  However, the component of the Lifecycle fund invested in a bond portfolio will fall in value when interest rates rise. 

Both bond and stock funds fell in tandem during the past year.  Lifecycle investing did not protect investors during the latest market downturn. 

Most retirees put all funds in instruments without a maturity date and base disbursements on a guideline like the four percent rule.  The four percent rule is not going to work if the value of both your stocks and bond funds simultaneously declines as they did most recently.

Retirees could and should purchase Treasury bonds and schedule the maturity of the bond for different dates each year.  The retiree would even consumption and reduce depletion of retirement assets by consuming from maturing bonds when the stock market is low and consuming from stock ETF distributions when the stock market is high.

Retirees with assets in bonds that mature on specific dates are better prepared for retirement than retirees with assets that have all savings tied up in funds without maturity dates.

Concluding Remarks:  The tax code provides preferences for investments in tax-preferred retirement accounts and 529 plans.  Congress recently passed legislation mandating automatic contributions to 401(k) plans. Financial advisors strongly recommend use of these tax-preferred savings vehicles.

Tax preferred savings vehicle often have limited investment options.

Tax-preferred savings plans often do not allow for the direct purchase of Treasury or government agency fixed-income securities with specific maturity dates, which could be matched with spending obligations.  

Moreover, financial advisors often advocate the use of bond funds instead of bonds with specific maturity date. 

Congress, through the tax code and their mandates and financial advisors through their insights guide investors to suboptimal higher-risk financial choices.

David Bernstein an economist living in Denver Colorado has written extensively on health and financial policy including a recent article outlining a 2024 Health Care Reform Proposal and an evaluation of President Biden’s student debt discharge proposal.

A 2024 Retirement Security Agenda

Pension and Social Security reform are inextricably linked because many retirees are highly dependent or Social Security, many workers nearing retirement are not in good financial shape and young adult are spending retirement funds early in their career. The recently enacted Secure Act 2.0 does very little to assist workers who are having the hardest time saving for retirement. Republicans and Democrats are far apart in their ideas on how to fix Social Security and neither party recognizes that meaningful enhancements in private retirement savings are essential to a successful Social Security reform. This post discusses ways to fix both the private retirement system and Social Security.

Introduction:

Many American workers are not preparing well enough for retirement.

Around half of older workers do not have any funds in a defined contribution plan (401(k) or IRA.)

The median amount of retirement assets for people with retirement plans is around $109,000.

Around 13.7 percent of the 65-and-over population lives in poverty.

More older workers are entering retirement with mortgage debt or consumer debt.

Many older workers cannot remain in the workforce because of poor health.

Economic downturns tend to result in a larger increase in unemployment for older workers than for younger or middle-aged workers.

Around 40 percent of older Americans are entirely dependent on Social Security.

Current law links future Social Security payments to the balance in the trust fund. Projected decreases in the trust fund would lead to a 20 percent in Social Security benefits in 2035, barring changes to the trust fund or current law.

Nearly 60 percent of young workers between the ages of 18 and 34 have already taken funds out of their retirement accounts to maintain current spending.   Early disbursements from retirement plans by young adults are especially high for people with high levels of student debt.

The traditional 60/40 portfolio held by many retirees loses substantial value in a period where the stock market falls, and interest rates rise. 

Congress and the Administration have not prioritized retirement income issues and are not close to addressing the looming Social Security problem.

Documenting the lack of progress:

Our leaders are not moving us forward on efforts to increase private savings for retirement or on efforts to fix the looming Social Security problem.  

Congress has passed some legislation, most recently, the Secure Act 2.0, impacting savings through 401(k) plans and IRAs.  Unfortunately, the recently enacted law does more to benefit investment firms and high net-worth savers than the workers who are struggling the most to save for retirement.  A more complete description of the Secure Act 2.0 can be found here and some of its shortcomings are listed below. 

  • Delays in implementation of Required Minimum Distribution do not assist retirees with low levels of retirement assets, people who tend to deplete their retirement accounts early in their retirement.  Provision increases fees received by investment firms.
  • Shorter waiting period for participation in 401(k) plans does not shorten vesting requirement and may benefit relatively few workers because many part-time workers do not stay at the same firm for a long time.
  • A provision clarifying that employers can contribute matching funds to 401(k) plans for student loan payments does not assist workers at firms without a 401(k) plan or firms with a 401(k) plan that do not match employee contributions.
  • The automatic 401(k) enrollment provision and automatic increases in contribution will reduce savings through other vehicles and will lead to relatively little additional savings if funds are distributed prior to retirement.

Around 40 percent of retired households are totally dependent on Social Security and many more are highly dependent on Social Security.    Expansion of private retirement spending is important by itself and has major implications for Social Security reform efforts.  

The implementation of some Social Security reform proposals that would lead to abrupt changes in benefits could not be applied to workers nearing retirement without causing large increases in poverty among the elderly.   

The Social Security trustees project that automatic benefit cuts to Social Security could occur in 2035 and that automatic Medicare benefit cuts could occur as early as 2028.

Democrats and Republicans are wide apart on what needs to be done to prevent automatic cuts to entitlement programs.  Democrats stress the need for additional revenue.  Republican proposals often call for large benefit cuts, many of which are applied to workers nearing retirement.

One proposal that could receive some bipartisan support inside a larger package involves increasing the cap on wages subject to Social Security taxes.  Current rules apply Social Security taxes to the first $160,200 of wages.  Go here for a discussion of proposals to eliminate or modify the cap on Social Security taxes.

Republicans tend to favor plans to reduce benefits, raise the retirement age, and create private accounts to replace all or part of the current Social Security system.  Some of the Republican proposals discussed herewould result in quick changes impacting potentially impacting workers close to retirement.   For example, a proposal to increase the retirement age for full Social Security benefits by 3 months per year until 2040, when the full retirement age reached 70 would result in substantial poverty among the elderly because private retirement savings could not be increased in this time frame.

Timely changes to Social Security are essential to prevent automatic benefit cuts that would lead to large increases in poverty because of the lack of private retirement savings.  

Reforming private retirement savings:

Reforms of private retirement savings that expand savings for low-income and middle-income households are a prerequisite for meaningful Social Security reforms because so many households are dependent on Social Security.   

There are six problems preventing workers from accumulating sufficient retirement savings prior to retirement.  Steps must be taken to address each problem. 

First, workers are free to disburse all entire savings from their 401(k) plans prior to retirement. Around 60 percent of young workers have tapped part of their retirement savings prior to age 34.  Steps must be taken to restrict pre-retirement disbursements from retirement plans and to incentivize workers from reducing retirement savings prior to retirement.

Proposed policy changes to address pre-retirement leakages from retirement accounts include:

  • Prohibit pre-retirement distributions from retirement plans for 25 percent of all contributions.   The prohibited distributions could be used to purchase an annuity that would not pay out until the retiree reaches a certain age.
  • Require automatic rollover into IRAs for all workers making a job transition with 401(k) balances less than $50,000.  (Current law allows but does not require automatic rollovers.)
  • Prohibit loans from 401(k) plans. Replace loans with limited tax-free and penalty-free distributions from the newly created emergency funds inside a 401(k) plan.

Second, workers reliant on Individual Retirement Accounts (IRAs) have less generous saving incentives than workers with access to employer-based 401(K) plans. Workers dependent on an IRA without access to a 401(k) have a lower contributions limit, do not have access to an employer match, and do not have access to retirement incentives for student loan payments.

Proposed changes to rules that reduce or eliminate discrepancies between savings through IRAs and savings through 401(k) plans include:

  • Create automatic contributions to IRAs for people without access to employer-sponsored 401(k) plans, patterned after the rules that are currently applied to automatic enrollment into 401(k) plans.
  • Change tax law to allow for employers to make matching contributions to worker contributions to IRAs like the ones currently allowed for 401(k) plans.
  • Equalize IRA and 401(k) contributions limit and deductibility limits on IRA and 401(k) contributions.  
  • Change tax law to allow tax-free contributions to IRAs by firms hiring contractors or gig workers instead of direct employees.

Third, the current tax preference for contributions to 401(k) plans and deductible IRAs favors higher income people with higher marginal tax rates.  Tax savings from expenditures from Roth IRAs in retirement also disproportionately benefit higher-income taxpayers.  Income related gap in subsidies could be altered by changes to the tax code.

  • Replace existing tax exemption for contributions to traditional 401(k) plans and the tax deduction for contributions to deductible IRAs with a tax credit.
  • Create a tax credit for first $2,000 contributed to a retirement plan and allow tax deduction for additional contributions up to a cap.

Fourth, many workers are now diverting retirement savings to health savings accounts and flexible savings accounts to pay for health expenses that are no longer covered by health insurance.  This is a growing problem due to the growing use of high-deductible health plans.

Proposed policy changes to offset the loss of retirement income due to the growth of cost-sharing between insurance companies and insured households include:

  • Allow for the use of health savings accounts for people with lower deductible health plans to reduce the need for large contributions to health savings accounts.
  • Change rules governing flexible savings account to allow people to place unused flexible savings account funds in a 401(k) plan or IRA rather than lose the unused funds.  It would be appropriate to tax funds transferred from a flexible savings account to a retirement account.

Fifth, fewer than 15 percent of retirees have an annuity inside their retirement plan.   The primary reason for the low level of annuity income is the cost of annuities.

  • Mandate that 25 percent of funds contributed to a retirement plan be used to purchase an annuity.

The source of funds for the mandatory annuity purchase could be the funds the person is not allowed to disburse prior to reaching retirement age.

The rule requiring all workers make an annuity purchase would lower annuity prices because voluntary annuity purchases are favored by healthy people with long life expectancy.   

Sixth, retirees often suffer when inflation erodes the value of bond and stocks. Many workers cannot afford to save much outside their retirement plan and current tax law does not allow individuals to purchase series I bonds inside a 401(k) plan or an IRA.  Many assets inside a 401(k) plan that proport to be inflation hedges lose value in an inflationary or high interest rate environment.

  • The most effective way to prevent reduction in retirement plan wealth in a period when inflation and interest rates rise, and stock prices fall is to allow and encourage the purchase of Series I savings bonds inside a 401(k) plan or IRA.  Series I savings bonds never fall in value and have substantial upside in an inflationary environment.   Go here for a discussion of advantages of Series I Savings Bonds.

The primary effect of the current restrictions on Series I Savings bonds is to increase the demand for financial assets and ETFs that are less effective in protecting investors from inflation than Series I Bonds.

Reforming Social Security:  

The expansion and improvement of private retirement savings options will reduce dependence on Social Security by future generations and allow for the consideration of a broader range of Social Security reform options including eventual reductions in benefits.

The Social Security reform measures considered here include:

  • A new tax earmarked for Social Security and Medicare.    The tax would be imposed on all forms of income and would have a progressive tax structure.
  • Increase in both the minimum retirement age for Social Security benefits and the age for full benefits, by one year each phased in over a 24-year period with a one month increase in the retirement age every two years.   The age at which people receive the maximum allowable Social Security benefit would remain unchanged.
  • Guarantee future Social Security benefits by allocating some general tax revenue towards future benefits if the Trust fund balance falls to a certain level.

Economic Notes on the Policy Package:

  • The combination of tax credits to stimulate private retirement savings, tax increases to fund current Social Security and Medicare benefits and long-term increases in the retirement age create a healthy macroeconomic environment and will lower household financial distress in retirement.
  • Short-term changes in tax revenue will be modest because losses in tax revenue from tax credits to stimulate private retirement savings are offset by increases in tax revenue from the new tax to maintain Social Security and Medicare benefits.
  • The phased in increases in the retirement age will not have an immediate impact on government deficits but will reduce future Debt-to-GDP ratios.   Since markets are forward looking the projected lower future debt burdens will have a beneficial impact on asset prices even if near term deficits rise. 
  • The tax base to continue funding Social Security and Medicare benefits should be relatively broad.  The tax could be imposed for all households making more than $50,000.  The tax would be progressive.  The marginal tax rate might range from 0.5 percent to a cap of 5.0 percent.  The tax would be applied to both wages and investment income.

Concluding Remarks:  Unless changes are made to rules governing Social Security and Medicare there will be automatic benefit cuts once trust funds assets are partially depleted. Many Republicans favor large and abrupt changes to Social Security benefits and the retirement age.  Any abrupt change in benefits would have an extremely adverse impact on household poverty and on aggregate demand.

A reduction in Social Security benefits that is not preceded by a substantial expansion in private retirement savings by the workers who are now having the most difficulty saving for retirement would lead to catastrophic financial impacts for many households.  This outcome can only be avoided by coupling private pension reforms with Social Security reforms.

David Bernstein is the author of A 2024 Health Care Reform Proposal.

Evaluating the Secure Act 2.0

Most of the provisions in The Secure Act 2.0 have at best a modest impact on 401(k) participation and retirement savings. The proposals do not target households likely to have inadequate retirement income. Congress should not enact this law. An alternative approach would expand incentives for people without employer-based retirement plans.

Introduction:

The major provisions of the Secure Act 2.0, summarized here by CI Private Wealth, include changes to rules governing required minimum distributions (RMDs), increased access to 401(k) plans for part-time workers,  larger catch-up contributions for older workers, changes to qualified charitable distributions, employer matching contributions  to 401(k) plans for student loan payments, mandatory automatic enrollment into 401(k) plans, and employer matching contributions for Roth 401(k) accounts.

There are merits to some aspects of these proposals.  However, changes to pension rules currently in Secure Act 2.0 do not provide major benefits to people who are struggling to save for retirement. 

Larger improvements to retirement savings for more households could be achieved at lower cost to the government by expanding Individuals Retirement Accounts (IRAs) instead of expanding firm-based retirement plans.

Discussion of Specific Proposals:

Modifications to RMD rules:  

Changes:

The Secure Act 2.0 has a proposal to delay required minimum distributions from retirement accounts.  The current RMD age is 72.  The proposal increases the RMD age to 73 in 2023, 74 in 2024, and 75 in 2031.  The Secure Act 2.0 also reduces the penalty for not making a RMD from 50 percent to 25 percent.

Comments:

These proposals are unlikely to benefit people with relatively modest income who must withdraw more than the RMD from their retirement account to fund current needs in retirement. This change will NOT reduce the number of households who might outlive their retirement savings.

It is unlikely that workers currently saving for retirement consider the RMD when makings savings decisions because tax savings from contributions to retirement accounts are already large. These changes to RMD rules will not incentivize increased retirement savings for current workers. 

RMD requirements only pertain to traditional retirement plans.  Roth accounts do not have RMD requirements.  These changes could discourage some workers from contributing to Roth accounts or converting traditional retirement assets to Roth assets.  

Many investment firms will automatically limit retirement plan disbursements to the RMD amount and will automatically increase the rate of spending of non-retirement assets for individuals who have not reached the RMD age.  This approach will increase fees to the firm managing the 401(k) plan but may be detrimental to the investor.  The major beneficiary of this proposal is pension fund managers who will receive more fee income because of the slower disbursements from retirement accounts.  

The increase in the RMD age will increase distributions and tax payments once the RMD age is reached because the retirement plan balance is larger, and the expected future life span is shorter.  The increased RMD age delays disbursements and taxes but could increase total lifetime tax payments for some households.  The increased RMD age could increase early depletion of Series I Savings bonds, (an asset outside of retirement accounts) leaving investors less prepared for an increase in inflation later in life.

Increased Access to 401(k) plans for part-time workers:

Changes:

The Secure Act 2.0 reduces the waiting time for part-time workers to make contribution to 401(k) plans.  The current waiting period is three years.  The proposed waiting period is two years.

Comments:

Many small firms with a large percentage of part-time workers do not offer 401(k) plans.

This proposal will not help part-time workers without a continuous employment history.   Many part-time workers are seasonal and do not have continuous employment at a firm.

This reduced waiting period does not affect vesting requirements.  Part-time workers are subject to the waiting period and the vesting requirement.  A part-time worker at a firm with a 401(k) plan that has a three-year vesting requirement would have to work at the same firm for five years to fully vest.

401(k) plans at firms with a high proportion of part-time workers tend to have high fees.  Many part-time workers would be better off contributing to a low-fee IRA instead of a high-fee 401(k).

It would be easier and more effective to motivate retirement savings for part-time workers by increasing incentives for contributions to IRAs.  This approach benefits all workers as soon as they are employed, workers at firms that do not offer 401(k) plans, and workers with multiple jobs.  

Larger catch-up contributions for older workers:

Changes:

The Secure Act 2.0 increases catch-up contribution to firm-sponsored retirement plans for people aged 62-64 from the current level of $6,500 to $10,000.  The current catch-up contribution remains the same for people between age of 50 and 61.  The proposal indexes the current catch-up contribution for IRAs to inflation and provides for a more modest increase in catch-up contributions for Simple Plans.


Comments:

The Secure Act 2.0 increases the disparity between allowable catch-up contributions for employer-based retirement plans and IRAs.  The goal of pension reform should be reducing all disparities between employer-based retirement plans and IRAs including disparities in catch-up contributions because the people most in need to additional retirement assets currently do not have access to employer-based plans.

Many low-income and middle-income workers nearing retirement are better off reducing debt than increasing contributions to 401(k) plans.  Go here for a post documenting the advantages of debt reduction prior to retirement.

Changes to Qualified Charitable Distribution Requirements:

Changes:

The Secure Act 2.0 increases potential charitable distributions from retirement plans and associated tax benefits.    The charitable distribution is also indexed to inflation.

Comment:

This is a useful change for well-heeled savers, charities and people benefiting from charities.  However, this provision does nothing for people with limited retirement resources who may out-live their retirement wealth.

Student Loan Matching:

Changes:

The Secure Act clarifies the tax code to make clear employers are allowed to contribute matching funds to retirement plans for workers making student loan payments, even if the worker does not make contributions to the plan. 

Comments:

This proposal does not benefit workers at firms that do not offer a retirement plan or workers at firms with a retirement plan that do not match employee contributions.  As a result, this provision will disproportionately benefit workers with better jobs and will do little to reduce student loan debt burdens for people most affected by student debt.

Mandatory Automatic Enrollment:

Changes:

The Secure Act 2.0 requires employers with an employer-based retirement plan to automatically enroll new employees who are qualified for enrollment into the plan.  The initial automatic enrollment is set at 3.0 percent of income.  The automatic enrollment is increased by 1.0 percent per year up to 10 percent of income.

Comments:

The government sanctioned automatic enrollment provision implies that the government believes that contributions to firm-sponsored retirement plan are the best use of funds.  This argument may not be correct in many circumstances including when workers have high debt levels, when the employer does not match contributions, and/or when the plan charges high fees.  

The case for automatic enrollment in 401(k) plans is strongest when firms match employee contributions.  A modified automatic enrollment provision limited to firms with matching contributions for contributions up to the amount needed to receive the entire match would be superior to the current provision.  Automatic enrollment of funds beyond this level is difficult to justify given the existence of other investment options including Roth IRAs and Series I Savings Bonds.

The case for automatic enrollment for newly eligible employees is stronger than the case for automatic increases in contributions.  Employers or plan managers could provide advice about desired contribution levels instead of assuming one strategy fits all workers.

Other automatic pension changes including automatic rollover of high-fee 401(k) funds to low-fee IRAs when employees leave a firm and automatic enrollment of workers at firms without a 401(K) plan into IRAs should be considered.

Matching Contributions to Roth Accounts:

Changes:

Starting in 2023, employer-matching contributions could be placed in a Roth account.  Current law places employer-matching contributions in a conventional account while the employee contributions are placed in a Roth account.

Comments:

Under current law, employer contributions are not taxed in the year of the contribution. A provision an untaxed employer contribution into a Roth account would result in the contribution never being taxed.  Presumably, if the employer contribution is placed in a Roth account it would be fully taxed in the year of the contribution.  

The proposal only benefits workers at firms with a 401(k) plan that matches contributions and has a Roth option.

This proposal does not pertain to Roth IRAs because no employer contributions are allowed in any IRA.  An expansion of matching contributions to IRAs would better assist households who are having difficulty saving for retirement.

Concluding Remarks:

The Secure Act 2.0 is not yet law.  It must be reconciled with Senate provisions that include provisions for expanded access to emergency funds through retirement accounts.  A blog post describing these proposals can be found here.  

The Secure Act 2.0 is not an effective way to improve retirement security for American workers. 

Many of its provisions give larger benefits to investment firms than to workers saving for retirement.  The bill provides scant assistance to the workers who are having the most difficult time saving for retirement. A more effective approach involves expanding saving through individual Retirement Accounts instead of firm-sponsored retirement plans.

Authors Note:  David Bernstein, an economist and author, has written An Alternative to the Biden Student Debt Plan.  This paper is a must read now that the Biden plan is tied up in court.  David is an economic consultant taking on new clients.  He can be reached here or can be emailed at Bernstein.book1958@gmail.com. 

Should Retirement Plans Include an Emergency Fund?

Many workers are currently disbursing a substantial share of their retirement fund prior to retirement. The addition of an emergency fund inside a retirement plan should be coupled with new limitations on pre-retirement disbursements

The House has passed a bill enacting several changes to rules governing IRAs and 401(K) plans.  The Senate is considering modifications to the House bill that will make it easier for workers to use retirement funds for emergencies.  This blog post examines three proposals that are currently under consideration by the Senate.

Proposal One:  The Emergency Savings Act of 2022:  A bill offered by Senator Booker and Senator Young would allow employers to create an emergency fund inside a firm-sponsored retirement plan.  The money in the emergency fund could be disbursed without penalty or tax at any time.   

Comment One:  One purpose of the emergency fund is to facilitate increased contributions to 401(k) plans by people with limited liquidity.  Paradoxically, the emergency fund might not increase funds for emergencies if the household is living paycheck to paycheck.  The new fund does not increase total financial resources available to households.    The new fund does not prevent households from overspending.  An increase in 401(k) contributions associated with lower rates of repaying consumer or student debt could make some households worse off.

Comment Two:  The bill does not increase liquidity or savings incentives for people with a Roth retirement account.  The Roth account already allows disbursements from contributions without penalty or tax prior to age 59 ½. An alternative way to increase use of retirement funds for emergencies is to encourage increased contributions to Roth rather than traditional retirement accounts.

Comment Three: The rationale for a tax deduction for contributions to 401(k) plans and IRAs is that the tax deduction incentivizes savings and makes both the worker and society better off. This bill gives workers a tax deduction even if they immediately spend all funds placed in the emergency account. The bill does not prevent workers from distributing all funds in their 401(k) plan by paying a 10 percent penalty and tax on the distribution.  The goal of facilitating retirement savings and the goal of having emergency funds could be better balanced if the new emergency fund was coupled with a limitation on pre-retirement withdrawals.  

Proposal Two:  The Refund to Rainy Day Proposal: This plan requires the Secretary of the Treasury to create a mechanism through which people can place part of their tax refund into a Rainy Day Fund.  

Comment One:  The Treasury already allows for direct deposit of refunds to financial institutions. Private financial firms could set up a direct deposit to an emergency fund. The Treasury Direct site could create an option where some of the proceeds were automatically invested in short-term Treasury securities.

Comment Two:  People with large tax refunds are probably less in need of emergency funds than people who owe taxes because people with little liquidity have a large incentive to increase their claimed exemptions to meet current needs.  This tax refund provision does not assist the people most in need of emergency funds.

Comment Three:  It is not clear why the government should favor direct deposit of tax refunds into emergency funds over other priorities including direct payments of student loan debt or direct contributions to health savings accounts.

Comment Four:  I don’t see anything in this bill that increases the financial capability of households or alters household savings behavior.

Proposal Three:  The Enhancing Emergency and Retirement Savings Act of 2021:

This plan offered by Senator Lankford and Senator Bennet would provide a penalty-free distribution from retirement plans, both in firm-sponsored plans and individual retirement accounts.  The plan provides for one emergency distributions per year if the account has $1,000 vested funds.  The maximum withdrawal would be $1,000. The legislation requires replenishment of the withdrawn amount prior to additional withdrawals.  

Comment One:  A worker who is replenishing an initial withdrawal has an incentive to reduce 401(k) contributions to maintain consumption.  This proposal will have at best a modest impact on retirement savings, especially for workers entering the workforce with substantial student debt.

Comment Two:  I presume (perhaps falsely) that this penalty-free option is optional.  Some firm 401(k) plans and some IRA management firms might choose to not offer this option to keep administrative costs and fees down. The impact of the provision on administrative costs and returns on retirement funds could be considerable. 

Comment Three:  Some 401(k) plans will provide emergency distributions and 401(k) loans.  Workers who take both an emergency distribution and a 401(k) loan will owe substantial funds to their plan.  Many of these workers will not replenish the emergency fund or repay the loan.  Many of these workers will have an incentive to tap their entire 401(k) plan if they switch jobs.  It would be easier to justify the creation of an emergency fund inside a 401(k) plan if the proposal were linked to some limitation on complete disbursements prior to retirement.

Concluding Remarks:  

The proposals considered in the Senate increase access to retirement funds for emergencies.  One goal of these provisions is to incentivize workers to increase contributions to retirement plans.  However, under the current system many workers routinely distribute and spend substantial funds in their retirement prior to retirement.

Several studies indicate that the use of 401(k) funds prior to retirement is widespread and is a major factor impacting the number of households who might retire with inadequate financial resources in the future. Research from E-Trade financial, reported on CNBC in 2015, revealed that nearly 60% of millennials had already taken funds out of their 401(k) account. A study by the Employment Benefit Research Institute (EBRI)reveals that 40% of terminated participants elect to prematurely take out 15% of plan assets.  A recent study by Wang, Zhai, and Lynch found that over 40 percent of employees cashed out their 401(k) plan at separation.

Intuitively, the people most likely to tap funds from their 401(k) plans prior to retirement are struggling financially.   My own study found here, reveals that people tapping funds prior to retirement tend to have high levels of debt and poor credit ratings.  The sheer magnitude of the number of people who are both lacking in liquidity and tapping retirement funds suggests leakages from 401(k) plans will weaken retirement security for many households.

Any revisions to rules governing emergency distributions from retirement plans should be coupled with rules limiting distributions from retirement plans prior to age 59 ½. 

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.

2024 Economic Issues: The Case for Expanding and Improving Individual Retirement Accounts (IRAs)

Workers without access to firm-sponsored 401(k) plans often do not save enough for retirement. Insufficient retirement savings caused by lack of access to 401(k) plans could be more effectively reduced by expanding and improving Individual Retirement accounts (IRAs) instead of expanding the use of 401(k) plans.

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.

Comments:

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.


Student Debt Proposal #4: Reducing tradeoff between retirement saving & student debt repayment

Reforms centered on increased use of Roth IRAs would better balance saving for retirement and student debt repayment than the Secure Act 2.0 reforms.

Introduction:   Tax and financial incentives are more generous for contributions to 401(k) plans than for the repayment of student debt.

  • Workers are allowed to to save untaxed dollars in a firm-sponsored retirement plan or an individual retirement account.
  • Firms can match employee contributions to the 401(k) plan. Two common 401(k) matching formulas are 50 percent of the dollar amount contributed by the employee up to 6.0 percent of the employee’s salary and 100 percent of contributions up to 3 percent of the employee’s salary. 
  • Student borrowers can deduct up to $2,500 of interest on student loans.  
  • The student loan tax deduction pertains exclusively to interest while the entire 401(k) or IRA contribution is exempt from taxes.
  • There are no matching contributions for student loan repayment.

The decision to prioritize 401(k) contributions over student debt repayment does not always work out well as discussed in a previous post.  Potential consequences include:

  • Higher total loan payments associated with selection of longer loan maturities.
  • Higher borrowing costs stemming from higher debt levels and lower credit ratings.
  • Early disbursements of 401(k) funds leading to penalty and tax payments.
  • Increased likelihood of having debt obligations in retirement.

Student borrowers who quickly repay their loans would increase saving for retirement, realize lower borrowing costs, start the process of paying off their mortgage and would basically be much better off.  

There is general agreement that student debt significantly impedes saving for retirement by young households.  There is, however, no real consensus on how to fix this problem.

Proposed modifications to 401(K) plans in the SECURE Act 2.0, which would induce some student borrowers to begin saving through a 401(k) plan, don’t solve this problem. Expanded incentives for the use of Roth IRAs by student borrowers would be far more effective than expanded incentives for 401(k) contributions.

The Secure Act 2.0:

Wall Street favors and greatly benefits from incentives for 401(k) investing. The Secure Act 2.0 maintains the high priority attached to 401(k) saving and facilitates participation in 401(k) plans by student borrowers.  

The Secure Act 2.0 has the following features:

  • Requires automatic enrollment of employees in 401(k) plans
  • Requires all catchup contributions be designated as Roth contributions
  • Allows designation of matching contributions to a Roth account 
  • Delays mandatory distributions
  • Reduces waiting period for 401(K) contributions from 3 to 2 years for part-time workers.
  • Authorizes 401(k) matches for student borrowers even if they do not participate in a 401(k) plan.

The general purpose of the Secure Act 2.0 is to expand investments through 401(k) plans.

Many people who rely on high-cost 401(k) plans often end up paying a substantial portion of their savings to Wall Street. Go here for a discussion of the impact of 401(k) fees on retirement. 

The proposal only benefits student borrowers at firms with 401(k) plans, workers at firms with plans offering matching contributions, and workers eligible for the 401(k) plan.  

Many student borrowers will not benefit from this provision in Secure Act 2.0 including:

  • Self-employed workers and people employed by firms not offering a 401(k) plan.  Only 53 percent of small and mid-size firms offer a 401(k) plan.
  • People at firms with 401(k) plans that do not match employer contributions. Around 49 percent of all firms do not offer an employer match.
  • Employees who are ineligible for the firms-sponsored 401(k) plan.  Around 24 percent of firms require one year of service for entry to the firm-sponsored 401(k) plan.
  • Employees eschewing 401(k) plans due to  vesting requirements.

It is reasonable to anticipate that increased 401(k) contributions by young adults with student debt will fail to increase retirement wealth because, as evidenced by this CNBC article, around 60 percent of young adults end up raiding their retirement savings earlier in the career.

An Alternative Proposal, Incentives for Increased Use of Roth IRAs:

A more equitable and efficient way to balance the goal of saving for retirement with rapid repayment of student debt is through incentives to increase contributions to Roth IRAs instead of 401(k) plans

This could be accomplished by modifying the SECURE Act in the following fashion.

  • Mandate automatic contributions to Roth IRAs instead of automatic contributions to 401(k) plans 
  • Mandate automatic use of low-cost highly diversified IRAs unless person opts for a different investment strategy
  • Allow employers to match contributions to Roth IRAs or contributions to 401(k) plans
  • Allow employers to give employer matches to holders of Roth IRAs even if the student borrower does not contribute to the Roth IRA.
  • Prohibit distributions from investment income inside Roth IRAs prior to age 59 ½. 

A strong case can be made that many workers should maximize the use of Roth IRAs instead of traditional IRAs even under current law.

  • There are substantial tax savings in retirement from the use of Roth IRAs from two sources. First, the distribution for the Roth IRA is not taxed during retirement.  Second, the Roth distribution does not count towards the income limit leading to the taxation of Social Security benefits.  Households that rely primarily on Roth distributions in retirement often do not pay any tax on their Social Security benefits.
  • Distributions from Roth contributions prior to age 59 ½ are not subject to income tax or penalty.  This feature benefits young adults who tend to raid their account prior to retirement and pay taxes and penalty.
  • The Roth account does not allow 401(k) loans, a feature that causes people to distribute funds and even close the entire account prior to retirement. 

This proposal encourages student borrowers who are ready to save for retirement to choose a Roth IRA instead of a 401(k) plan.  The change will increase retirement saving for several reasons

  • Some firms without a firm-sponsored retirement plan may provide an employer match to an IRA because there should be no administrative costs imposed on the firm for this type of contribution
  • The automatic selection of a low-cost IRA will usually result in lower fees and higher returns compared to the default 401(k) option. 
  • The restriction on distributions from investment income until after age 59 ½ prevents people from distributing all retirement assets and closing the retirement plan prior to retirement. 
  • The IRA could receive matching funds from multiple employers.

Both the Secure Act 2.0 reforms and the alternative one presented here favor Roth accounts over traditional accounts.  The use of Roth accounts favors low-income student borrowers because their marginal tax rate and deduction for contributions to traditional 401(k) plans is low.  

The use of Roth accounts by low-income low-marginal-tax-rate workers facilitates diversion of some assets for debt repayment because the holder of the Roth requires less wealth to fund a sufficient retirement.  

Concluding Remarks:  Wall Street and financial advisors consistently advise their clients to prioritize 401(k) contributions over rapid repayment of student debt.  This approach is not leading to a secure financial life for many student borrowers who are paying more on student debt over their lifetime, incurring high borrowing costs on other loans, having trouble qualifying for a mortgage and raiding their 401(k) plan prior to retirement.   The use of Roth IRAs and rules allowing employers to match contributions into a Roth rather than contributions into a 401(k) will help student borrower better balance student debt repayment and retirement saving.

The more rapid repayment of student debt might also be facilitated by a partial discharge of student debt after around 60 on-time payments as describe in this post.

A list of student debt post presented here will be updated with new articles when available.

Financial Tip #12: Impact of mortgage debt on longevity risk

The existence of mortgage debt in retirement is shown to substantially increase the likelihood a person will totally deplete their retirement account and will have to rely exclusively on Social Security and Medicare for all expenses.

The Situation:  Consider a person who took out a 30-year mortgage, 15 years prior to retirement.   The initial balance on the mortgage was $600,000 and the interest rate on the mortgage was 3.6 percent.

The person retires with $1,000,000 in her 401(k) plan but the retiree also has an outstanding mortgage of $378,975 and an ongoing monthly mortgage payment of $2,728.  

The retiree plans to spend $40,000 per year $3,333 per month to cover non-housing consumption in retirement. 

  • The total annual disbursement from a 401(k) plan for a person with a mortgage is $72,735.
  • The total annual disbursement from a 401(k) plan for a person without a mortgage is $40,000.

Question One:  What are the outstanding balances of the retirement plan after 15 years for a person with a mortgage and a person without a mortgage if the rate of return on investments in the retirement plan is 6.0 percent per year?

Answer:  

  • The outstanding 401(k) balance after 15 years for the person with a mortgage is $691,380.
  • The outstanding 401(k) balance after 15 years for the person without a mortgage is $1,484,698.

Question Two:  What are the 401(k) outstanding balances after 15 years if the person started retirement with $900,000 in 401(k) assets.

Answer:  

  • The person with the mortgage has a 401(k) balance of $445,971 after 15 years.
  • The person without a mortgage has a 401(k) balance of $1,239,290 after 15 years. 

Implications for longevity risk:

The existence of a mortgage payment substantially increases the depletion rate of the 401(k) plan. The mortgage payment cannot be avoided during market fluctuations.  The existence of a mortgage during a market downturn at the beginning of retirement can have an especially adverse impact on retirement wealth.

The discussion presented here does not explicitly consider taxes.

  • All traditional 401(k) assets are fully taxed as ordinary income.   
  • The person with higher spending due to a mortgage will have also have higher taxes.
  • This person may increase spending to have adequate non-housing consumption.

More on these issues will follow.

Technical Note:  Discussion of Financial Calculations

The most straight forward way to obtain the 401(k) balance is to set up a spreadsheet where the loan payment is subtracted from the balance each month and the balance minus the loan payment earns a monthly return.   

A second approach involves the use of the FV function.  

The arguments of the FV function are

  • Rate 0.06/12 or 0.005.
  • NPER 12*15 or 180.
  • PMT 6061.21 for person with a mortgage and $3,333.33 for person without the mortgage.
  • PV -1,000,000. Negative because PV is cash in and must be the opposite sign of the PMT function.

The FV function is set up to analyze loans, so be careful with the sign of answer.

The logic of the spreadsheet approach is easier to follow.

Financial Tip #11: Roth Conversions Early in Retirement

People entering retirement with liquid assets outside of their retirement account should delay claiming Social Security benefits, delay disbursement from traditional retirement plans and convert traditional retirement assets to Roth assets. This strategy requires substantial liquid assets outside of a retirement account

A previous post explored the potential gains from converting traditional retirement assets to Roth assets whenever taxable income was low.  This post explores a specific situation, the conversion of traditional retirement assets to Roth assets early in retirement prior to a person claiming Social Security benefits. 

Discussion:  

Many financial advisors recognize the benefits from delaying claims in Social Security benefits.

Social Security benefits are reduced by 30 percent for workers born 1960 or later who claim retirement benefits at age 62 instead of 67. In addition, each month delay in claiming retirement benefits after reaching the full retirement up to age 70 age, increases benefits by 2/3 of 1 percent.  Go here to the SSA site for a discussion of advantages of waiting until the full retirement age to claim Social Security benefits.  Go here for a discussion of the advantage to claiming Social Security at age 70.

The potential gains from delaying 401(k) disbursements and delaying claiming Social Security benefits while converting traditional retirement assets to Roth assets have not been fully publicized.   

The strategy of converting traditional retirement assets to Roth assets early in retirement can be profitably implemented if the household has substantial financial assets outside of a retirement account to fund current consumption.  In some cases, these liquid assets can be obtained by a household downsizing to a smaller home and using the house equity to fund consumption.  

The cost of converting traditional retirement assets is the additional tax paid on the increased income stemming from the conversion.  A household in retirement not claiming Social Security benefits and not disbursing 401(k) funds will have a low marginal tax rate and low conversion costs.  

The benefits of the conversion of the traditional assets to Roth assets are the reduction in tax during the year Roth assets are disbursed instead of traditional assets. The amount of Social Security benefits subject to federal and state income tax is linked to modified adjusted gross income.  Since Roth disbursements are not taxed and not included in modified adjusted gross income the disbursement from a Roth instead of traditional retirement plan can have a substantial impact on taxes.  

Go here for a discussion of the taxation of Social Security benefits.

Funds obtained from investment returns on the conversion of conventional assets to Roth assets cannot be disbursed without penalty or tax for five years starting January 1 of the year of the disbursement.   The five-year rule pertains to investment returns on all conversions, even those that occur after age 59 ½. 

An example of returns from converting traditional assets to Roth assets in retirement:

This example of the potential advantages of converting traditional retirement assets to Roth assets early in retirement was published in this Tax Notes article.

A married couple — filing a joint return with $10,000 in investment income — converting $34,550 in traditional assets to Roth assets would have taxable income of $19,750 and would pay $1,975 in tax.  The cost of conversion in this instance is $1,975, the difference in tax paid with the conversion and the tax paid without a conversion. 

The investment of $34,550 in a Roth account that earns a 6 percent annual return would be slightly more than $46,000 in five years. The one- year conversion would, in this instance, pay for the $39,000 distribution and would leave $7,000 for future distribution. 

A household distributing $50,000 from a traditional retirement account would pay around $7,072 in tax.  The household that distributes $39,000 from a Roth account and $11,000 from a traditional account would pay approximately $400 in tax.  

The total tax savings from the conversion, assuming a 6 percent return on converted assets is around $7,700.

The rate of return on the conversion is estimated a 30.7 percent.

Concluding Remark:  People entering retirement can extend the longevity of their retirement savings by initially using non-retirement assets to fund consumption, by delaying claiming Social Security benefits and 401(K) disbursements, and by converting traditional retirement assets to Roth assets.

Financial Tip #10: Convert traditional 401(k) funds to a Roth when income is low

The cost of converting a traditional IRA to a Roth IRA, the additional tax paid on the amount of the conversion, is generally low in years where a person leaves the workforce. The potential tax savings in retirement is considerable.

Introduction:

Often people leaving the workforce raid their retirement plans to fund current consumption.  A departure from the workforce creates an opportunity for people to convert traditional retirement assets to Roth assets at low cost.  The low-cost conversion to Roth assets can substantially improve financial outcomes in retirement. Households are only able to make this low-cost conversion if they have a decent ratio of liquid assets to debts.

Analysis:

  • A previous post, financial tip #6, found that people leaving a firm with a high-cost 401(k) plan should roll over funds from the high-cost 401(K) to a low-cost IRA to increase wealth at retirement.   The rollover is often a prerequisite to converting traditional 401(k) assets to a Roth.
  • The tax code allows for the conversion of traditional IRAs to Roth IRAs. Distributions from a Roth account in retirement are not taxed and do not count towards the amount of Social Security subject to tax. The person converting previously untaxed funds in an IRA pays income tax on the converted funds in the year of a conversion.   The cost of converting traditional assets to Roth assets, the additional tax paid stemming from the conversion, is low when households have marginal tax rates.   
  • Marginal tax rates are lowest when a worker or a spouse leaves the workforce.  This can happen when a person returns to school, decides to care for a family member, becomes unemployed or retires.  
    • Conversion costs are $0 if AGI including the amount converted is less than the standard deduction ($12,950 for a single filer).
    • Conversion costs for single people filing an individual return are 10 percent of taxable income AGI minus the standard deduction for taxable income between $0s and $14,200.  Increases in taxable income up to $54,200 increase conversion costs by 12 percent, the marginal tax rate.
  • The potential gains from converting traditional retirement assets to Roth assets early in a career perhaps when returning to school are tremendous.   
  • A person leaving the workforce for school for a couple of years at around age 28 might convert $20,000 from a traditional IRA to a Roth at a cost of around $2,000.
  • The balance of the Roth account from this conversion after 30 years assuming a 6.0 percent return is $114,870. 
  • The direct tax savings from the conversion assuming a tax rate of 10 percent would be $11,487.  An indirect tax savings from the omission of tax on Social Security, assuming around $50,000 in Social Security payments spread over a couple of years, would be around another $5,000.  The conversion can be thought of as an investment of $2,000 leading to a return of around $16,000 in around 30 years.  The rate of return for an investment of $2,000 and a return of $16,000 in around 30 years is around 7.2%.
  • A person in a low tax bracket because she is young and single and returning to school and only working for the part of the year could be in a much higher tax bracket in retirement, especially if married and both spouses worked and claimed Social Security.  In many cases, the returns from converting a traditional IRA to a Roth will be much higher than the one reported by the simple example in the above bullet. A person living 100 percent on Roth distributions and Social Security could easily pay $0 in annual tax after accounting for the standard deduction.
  • A person returning to school full time with no reported earnings could convert an amount equal to the standard deduction to a Roth and pay no additional tax.  It would be irrational for a person with a 0 percent marginal tax rate to fail to make a conversion.
  • Workers leaving the workforce are often more concerned about meeting immediate needs than for planning for retirement.  However, conversion costs are small during a year a person leaves the workforce.
  • Workers leaving the workforce with debt or with 401(k) loans often distribute funds from their 401(k) plan, pay a penalty and tax, and are unable to rollover or convert funds to a Roth.
  • The five-year rule imposes tax and penalty on funds disbursed from a Roth IRA funded through a conversion from a traditional IRA within five years from January 1 of the year of the conversion.  A separate five-year waiting period is applied to each conversion.     The five-year rule applies for conversions after age 59 ½ even though all funds in Roth accounts funded by contributions can be withdrawn without penalty and tax at that age.  The purpose of the five-year rule for conversions and its implementation even after age 59 ½ is to prevent immediate access to funds in a traditional retirement account.  The five-year rule for conversions appears to apply to disbursements from both contributions and earnings for both pre-tax and after-tax IRAs. 

Concluding Remarks:   The cost of converting a traditional IRA to a Roth IRA, the additional tax paid on the amount of the conversion, is generally low in years where a person leaves the workforce.  The potential tax savings in retirement is considerable.

Several additional posts on IRA conversions are planned.  One post considers issues related to conversions of non-deductible IRAs in a procedure called a backdoor IRA.  A second post considers the advantages of converting pre-tax IRAs during retirement.