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Tue Nov 27, 2012, 07:33 AM

The 401(k) Is a $240 Billion Waste


Imagine there were no 401(k)s. You wouldn't stop saving for retirement, right? Right? Don't worry, I won't tell Suze Orman. Not that CNBC's personal finance guru would get mad at you -- according to a new paper, most households wouldn't sock away any less for their golden years if we eliminated 401(k)s. Which raises a $100 billion question...

Why subsidize retirement saving if the subsidies don't work?

As far as tax expenditures go, the one for retirement savings is a biggie. Remember, "tax expenditure" is just econospeak for the various deductions, exclusions, and preferential rates -- in other words, subsidies -- that litter the tax code. According to the Congressional Budget Office (CBO), excluding pension contributions and earnings from taxes will cost us about 1.2 percent of GDP over the next decade, or an average of $240 billion a year. That's a lot of spending -- that's what tax expenditures are, just disguised spending -- without much bang for the buck. Maybe just a penny's worth.

In fact, one penny's worth is exactly how much extra saving a dollar's worth of retirement subsidies produced in Denmark, according to the recent paper by Raj Chetty and John N. Friedman of Harvard, Soren Leth-Petersen and Tore Olsen of the University of Copenhagen, and Torben Heien Nielsen of the Danish National Centre for Social Research. In other words, we might be spending $240 billion to get people to save $2.4 billion more.

But don't the trillions of dollars in 401(k) accounts tell a different story? Not necessarily. There isn't enough data for the U.S., but Chetty et. al. looked at the numbers for Denmark, which has accounts similar to our 401(k)s, to examine how much more incentives to save get us to save. The first chart shows how much households contributed to tax-preferred accounts after subsidies increased and the second chart shows how much they contributed to non-tax-preferred accounts, again after subsidies increased. It's a bit hard to see, but the decrease in the latter almost completely offsets the increase in the former -- households saved an average of 1 cent more.

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Reply The 401(k) Is a $240 Billion Waste (Original post)
xchrom Nov 2012 OP
exboyfil Nov 2012 #1
PETRUS Nov 2012 #2
bemildred Nov 2012 #3
antigop Nov 2012 #4
On the Road Nov 2012 #5

Response to xchrom (Original post)

Tue Nov 27, 2012, 09:24 AM

1. Early in my professional career

I was told by a wise old engineer to pay myself first. From that point until a few years ago I was putting 15% of my income into a 401(k). With company match I am still close to 15%. I have saved a considerable amount in that account (and the subsequent IRA after the change of job roll over).

At least for me the 401(k) represents a method of savings outside of the tax code (which means I don't have to worry about the complexities of the code in my savings). I think this is an incentive for everyone to use this device. In addition you still pay taxes on the money when it is withdrawn. From a financial perspective it probably would have made more sense to pay taxes on the money when I earned it, but now I have options to retire at 59 1/2 on the account and draw it down until my Social Security and pension kick in.

It is good for individuals to have an equity position way to invest. Plans I have heard of that link savings to the acquisition of Treasury bonds worries me because a substantial part of your retirement savings is already represented by your continued trust in the faithfulness of the federal government (Social Security). IRAs allow individuals to be unconcerned about capital gains, dividends, and interest and how these various actions are treated for tax purposes.

Forcing someone already making minimum wage to contribute an additional 2 to 5% of their income into a retirement account is just cruel. They are relying on the subsidizing of Social Security in how their benefits are calculated. Social Security will be all that they have, and I am a strong proponent of making it stronger. It represents the best hope for those individuals. The only other argument would be to carve off a percentage of the current withholding and allow them to redirect it into a personal account (sounds like George Bush).

I have been a working engineer my entire professional career. I am not a rich person. I am thankful for the 401(k) and IRA plans. At least in my case they have motivated me to save.

The taxes get paid on IRAs eventually. In the event of death the non-spouse recipient has to pull all the money out in five years at ordinary tax rates. The tax liability of IRAs represents an asset for the government for future expenditures when this money is finally taken out for retirement.

Now if you want to focus on something that costs the treasury dollars lets look at trusts.

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Response to xchrom (Original post)

Tue Nov 27, 2012, 09:45 AM

2. K&R

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Response to xchrom (Original post)

Tue Nov 27, 2012, 10:26 AM

3. Tax deferred retirement savings is a good idea, but it is not a subsititute for

having defined benefit retirement plans for everybody who works,
and that is what we need Social Security for, 401k or not.

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Response to bemildred (Reply #3)

Tue Nov 27, 2012, 10:30 AM

4. +1000 n/t

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Response to xchrom (Original post)

Tue Nov 27, 2012, 11:55 PM

5. Sorry to Critical of the Article You Posted, Xchrom,

because it raises a legitimate issue that is undoubtedly being discussed as part of the fiscal cliff negotiations (or at least should be discussed).

This article, however, is atrocious. Whatever the merits of the author's proposal, his conclusion is not substantiated very well:

(1) In contrast to the quantitative academic studies cited, his argument for taxing 401k contributions as normal income is, literally reduced to: Imagine there were no 401(k)s. You wouldn't stop saving for retirement, right? Right. For a middle-income family, imposing a federal tax rate of 35% and additional state and local taxes means that the same savings would be worth about 1/3 to 1/2 less when they retire. This is a big deal. How many people would heavy up their savings for increased taxes? One can only guess, but it's probably not a whole lot.

(2) The author says that 401k tax breaks are 'wasted'. This comparison made only when comparing voluntary tax-free contributions to greater forced savings. I am all for better retirement planning, but Mr. O'Brien really, really needs to get out and experience how people who make less than the median income would be affected by the reduction in paychecks that would result from additional forced withdrawals from paychecks.

(3) The article invokes Suze Orman when she has absolutely nothing to do with this proposal. Furthermore, it leads with a large unflattering picture of her. Where it lacks an argument, it relies on a rhetorical question ("you wouldn't stop saving for retirement, right?") This is what propagandists do.

(4) The author assumes a misinformed reader. If this sounds familiar, it's because that's how the payroll tax works -- except it's how you think the payroll tax works now. There's a misconception that the money the government withholds from you every month ends up in an account with your name on it that eventually becomes your Social Security benefits. It doesn't. This is especially puzzling since readers of The Atlantic probably do not share this particular belief.

(5) The graphs are extraordinarily hard to interpret and lack some basic information in order to make sense of them, such as the "top tax cutoff" rate, the years involved, the exchange rate, average financial readiness for retirement in Denmark. They appear to be included not to shed light but to give the impression that the author's thesis has been confirmed by an academic study even if the reader cannot grasp the proof.

To get the context, it is necessary to pull up the original academic study (http://obs.rc.fas.harvard.edu/chetty/crowdout.pdf). Even that is not sufficient, and a number of other factors have to be researched independently. After poring over those charts and looking up some background material for an hour or so, all I can conclude is that when Denmark began offering tax breaks for retirement savings accounts, people above the "top tax cutoff" invested more in those accounts, a trend which was strongly correlated with income. (In other words, the wealthy invested more than those just above average.) Maybe this supports the author's proposal to eliminate 401k accounts in the US, but to put it kindly, it seems like a stretch.

Maybe taxing retirement savings is a good idea. But this article makes me more wary of it rather than less.

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