We’ve often heard that Americans do not save enough. That is mostly true, as about two-thirds of Americans save little or nothing.
This troubling fact is highlighted every time we have an economic downturn. Savings, often held in the form of investment accounts, can provide security in difficult times. If you get laid off, the account might help you get by for several months while you search for another job.
{mosads}To most of us, such accounts are mythical creatures. We all wish we had one, and we tell ourselves that if only we made a bit more money we definitely would. Because of this low level of savings, it makes sense that the government would try its best to encourage us all to save for retirement, one of the most vulnerable periods of our lives.
The tax system does this by favoring certain types of retirement plans (think, 401(k)s or IRAs). Employees and employers are able to make tax-free contributions to such plans. Though great in theory, for years, economists and tax scholars have known some ugly truths about these accounts.
They do a really bad job of encouraging new savings, especially by the low- and middle class-individuals in the most precarious financial situations. Instead, the vast majority of the financial assistance flows to those at the top of the income ladder.
Just as disturbing is the fact that these high-income individuals do not save more as a result of this tax incentive. They just move their investments around to take advantage of it. Basically, the government is cutting bigger checks to higher income taxpayers who already have savings, and Americans do not even save more as a result. We get no bang for the buck here.
This is a worsening situation because of some clever planning by tax lawyers and accountants. For decades, we thought that the traditional or old school pension was going away. For example, my father, who died last year at 95, was guaranteed a monthly check for life.
It was thought these kinds of pensions were too expensive since invariably there would be runaway costs from long-lived employees. Many plans went bankrupt or were converted to 401(k) type plans.
A 401(k) account allows the employer to shift the cost overrun risk to the employee. The amount in the retirement account at the end is dependent on market forces, and the employer does not insure the employee if the account runs out during retirement.
But there’s a disadvantage to the 401(k): High-income taxpayers can actually stash away more money in a traditional pension. The puzzle for these taxpayers was how to find a way to get the tax benefit of such pensions, without taking on the risk.
Enter the cash balance plan. Blessed by Congress in 2006, it has seen a dramatic rise among high-income groups like law firms, medical/dental practices and technology firms in the last decade. It is currently the fastest growing sector of the retirement plan market.
It manages to fit the definition of a traditional pension because the employer bears the risk. Yet, that risk is minimized by only guaranteeing a cash balance based on a conservative interest rate rather than some percentage tied to earnings of the employee.
Cash balance plans also allow high-income earners to lower their current income for tax purposes. There are a variety of tax benefits that have income cutoffs, so this lowered income also allows these taxpayers to qualify for other tax benefits, like the new 20 percent pass-through entity deduction, which is supposed to benefit small businesses.
Is there a solution? Is there a way for the government to actually incentivize those who need financial security to save more for retirement? Yes. Scholars, including myself, have proposed tax credit alternatives.
One proposal by economist William Gale would transform the current system into a refundable credit that is delivered directly into a retirement account.
This would result in the government cutting checks of the same size across income levels. It would also increase participation by the most socioeconomically vulnerable. Depending on how the proposal is tailored, it can be revenue neutral or revenue raising. That makes a lot more sense than the current reverse Robin Hood incentive.
Goldburn P. Maynard Jr. is the assistant professor of law at the University of Louisville Brandeis School of Law.