Saving in a 401(k) or IRA and taking the tax break is good for our personal finances. But shielding your money from income tax is not necessarily good for the country’s deficit.
Workers can defer paying income tax on up to $16,500 in a 401(k) and $5,000 in an IRA in 2011. For those age 50 and older, the limits jump to $22,000 and $6,000 respectively. Excluding 401(k) contributions from income tax cost the federal government $52.2 billion in 2010, according to the Office of Management and Budget. IRA tax breaks cost the federal government another $12.6 billion. Other employer-based retirement plans that allow workers to defer income tax on contributions cost $39.6 billion and Keogh plans cost $13.8 billion.
There is also a tax credit for low income workers who save for retirement. Individuals whose modified adjusted gross income is less than $28,250 ($56,500 for couples) in 2011 may claim the saver’s credit, which reduces income tax by up to $1,000 ($2,000 for couples), at a cost of $1.1 billion.
In total, all of these tax breaks and credits that encourage retirement savings cost us $119.4 billion in 2010. Retirement savings tax breaks cost less than excluding employer contributions for medical insurance premiums ($160.1 billion), but more than the home mortgage interest deduction ($79.2 billion).
President Obama’s deficit reduction commission proposed consolidating 401(k)s, IRAs, and other types of retirement accounts into a single type of tax-favored account. The National Commission on Fiscal Responsibility and Reform also suggests capping contributions to the lower of $20,000 or 20 percent of income and expanding the saver’s credit. The Bipartisan Policy Center’s debt reduction task force supports maintaining existing accounts, but capping contributions at the same annual limits indexed for inflation.
There are also additional expensive tax breaks for people who invest their savings outside of retirement accounts. The lower tax rate for capital gains costs us $36.3 billion, and the reduced tax rate for dividends is worth $31.1 billion. For those who pass on their wealth to relatives, not taxing capital gains on assets left to heirs in wills costs $39.5 billion. Both the National Commission on Fiscal Responsibility and Reform and the Bipartisan Policy Center support scrapping the 15 percent tax rate on capital gains and dividends in favor of taxing these investments at ordinary income tax rates.