A Shelter Or A Trap?

Low-income Americans who participate fully in a 401(k) plan or similar tax-deferred savings plan can pay more taxes over the course of their lifetimes, according to new research from the Federal Reserve Bank of Cleveland.

A 25-year-old couple that earns initially $50,000 a year with a 6% real rate of return would raise its tax bill by 1.1% and lower its lifetime expenditures by 0.4% if they participate fully in a 401(k) plan. If the couple earns an 8% real rate of return, the lifetime tax increase is 6.4% and lifetime spending reduction is 1.7%.

In comparison, a 25-year-old couple that earns $300,000 will receive a 6.7% tax break and a 3.8% increase in lifetime spending.

So how does an immediate tax shelter turn into a tax trap? The main reason is the taxation of Social Security benefits. Often times, taxpayers can be thrown into a higher tax bracket when they start taking retirement distributions. Depending on the amount of annual income, 50% to 85% of Social Security benefits could be taxed.

In addition, lower-income Americans could take smaller mortgage-interest deductions since 401(k) contributions lower employees’ tax brackets.

The study’s findings neglect the Economic Growth and Tax Relief Reconciliation Act of 2001, which expands the contribution limits to tax-deductible accounts, such as 401(k), 403b, Keogh, traditional IRAs and Roth IRAs.

The act provides a tax credit for qualified account contributions up to $2,000 made by low-wage earners. The study’s authors — senior economic adviser Jagadeesh Gokhale of the Federal Reserve Bank of Cleveland and colleague Laurence Kotlikoff of Boston University — believe the tax credit will have little impact on low-income households. However, if the credit is extended beyond 2007 and indexed for inflation, the credit would make tax-deferred savings at least a break-even proposition for low-income Americans.

Moderate-income households would pay more taxes from full participation even if the tax credit were extended and indexed.

Gokhale said the purpose of the working paper, " Who Gets Paid To Save?", was not to discourage Americans from saving for retirement. He said he views his work as a possible impetus for policy-makers to rethink the way 401(k) plans work and how employer’s matching contributions are given. He said employees could receive more benefits if the highly visible matching contribution were used to upgrade a company’s health-insurance plan or pension.

The authors state that if the government were to limit all workers to a $2,000 contribution to a Roth IRA, it would convert "a highly regressive public policy into one with some semblance of fairness."

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