Could cutting retirement tax incentives help fix Social Security insolvency?

A shrinking deadline to avoid automatic cuts to Social Security benefits in the next decade calls for rethinking the substantial tax subsidies for retirement savings, according to two economists.

Deferred tax payments on contributions to employer-sponsored plans, individual retirement accounts and other savings methods cost the federal government up to $185 billion a year. That money could instead be used to help ensure the long-term solvency of Social Security, a study by Alicia Munnell, director of the Center for Retirement Research at Boston College, and Andrew Biggs, senior fellow at the American Enterprise Institute, found earlier this year. The duo, veteran policymakers who served in presidential administrations on opposing sides of the aisle, argue that the "weight of the evidence indicates that tax incentives do not increase total savings in a meaningful way." Instead, reducing those incentives could fill part of the looming gap in Social Security financing.

Munnell and Biggs question whether the tax advantages of retirement savings have been effective in nudging more people who need to enroll in a 401(k) or open an IRA to do so. The percentage of workers participating in employer-sponsored retirement plans has hovered around 50% for the past 30 years, according to Fed data compiled by the authors. Citing available research on the behavior of retirement investors, they estimate that two-thirds of the savings would happen regardless of the tax advantages. In addition, they point out that many of the government tax expenditures for retirement savings flow to the wealthiest investors.

"Reallocating the proceeds from eliminating or reducing the retirement tax expenditure to Social Security could help Democrats and Republicans bridge the decades-long divide over whether to maintain Social Security's solvency by raising taxes or reducing benefits," Munnell, Biggs and co-author Michael Wicklein wrote. "Redirecting the tax expenditure to Social Security would reallocate existing federal resources that do not significantly improve retirement income security to a program that indisputably does. The front-loaded nature of savings from reducing the tax expenditure also could provide time for other changes to Social Security to be phased in. Finally, linking reductions to the tax expenditure to maintaining Social Security's solvency could overcome the legislative inertia that has for years delayed action on Social Security reform."

READ MORE: The definition of 'rich' — and its impact on taxes

Just as in many areas of federal policy, any potential Social Security reform will likely need to wait until after voters choose between President Joe Biden and former President Donald Trump. Cutting incentives for retirement savings in 401(k) plans and IRAs would likely prove difficult, especially after the recent Secure Act and Secure 2.0 Act explicitly provided new tax advantages for building up a nest egg. The study proposed a possible ceiling of the tax deferral once a retirement account tops $1 million or a reduction to $20,000 per year. The latest calculations from the Social Security Administration and the Congressional Budget Office found 75-year deficits of 1.3% to 1.7% of gross domestic product in the program.

"Both [estimates] project that Social Security's combined trust funds will be exhausted in the early to mid-2030s, an event that without increased revenues will trigger reductions to retirement, disability and survivors benefits," Munnell, Biggs and Wicklein wrote. "Thus, rollbacks of the ineffective retirement saving tax preference could fill a substantial portion of Social Security's long-term funding gap."

The design of the plan by Munnell (who was a member of the Council of Economic Advisers and assistant secretary of the treasury for economic policy in President Bill Clinton's administration after spending two decades at the Boston Fed) and Biggs (who was the principal deputy commissioner of the Social Security Administration and an associate director of the White House National Economic Council with President George W. Bush's administration) carries a couple of benefits, according to a blog by Howard Gleckman, senior fellow at the Urban Institute and Brookings Institution Tax Policy Center.

"First, it would use tax breaks that subsidize savings of mostly high-earners to preserve future Social Security payments," Gleckman wrote. "The public program is a critical source of income for low- and moderate-earners, who get only modest benefits from IRAs or employer-based retirement plans. Second, the cash infusion would buy time for Congress to make needed structural changes to Social Security."

Still, Gleckman argued that Congress "inevitably will take it all" and an even larger federal deficit and a bigger group of retirees "will be in exactly the same mess as today, just a few more years down the road." He gave the economists credit, though, for some "out-of-the-box thinking."

READ MORE: Social Security's insolvency date on collision course with retiring boomers

Since there is now less than a decade to go before Social Security beneficiaries could see an estimated 23% drop in their monthly checks, such ideas could prove helpful to policymakers waiting on Congress to take action on an issue that's often talked about without leading to any results. Retirement-plan companies would likely reject the notion of taking away any tax incentives for 401(k) and IRA accounts, though. 

Munnell and Biggs note that employer-provided pensions predated the federal income tax and the preferential treatment. They estimate that roughly $644 billion out of the $954 billion in annual retirement savings would have happened without the incentives. In those figures, the industry would see hundreds of billions of dollars in potential lost assets. In those figures, the industry would see hundreds of billions of dollars in potential lost assets. Still, the economists of different backgrounds found some common ground in their policy idea, which is what will be required of lawmakers to get Social Security on track to reach fiscal solvency.

Biggs and Munnell "are usually opponents" whose "disagreements go back decades" on policies like the privatization of Social Security and state and local government employee pay, Munnell wrote in a January editorial for MarketWatch. But she summed up their bipartisan idea thusly: "In short, let's move government resources from retirement plans where the incentive does virtually nothing for retirement security to a program that indisputably does — Social Security."