ProAssurance Corp., a Birmingham, Alabama-based liability insurance provider, automatically starts workers in its 401(k) plan by contributing the equivalent of 5 percent of their salary into their 401(k) accounts, even if workers don’t contribute a dime.
Then, it provides an incentive for workers to contribute more: It will match, dollar for dollar, an additional 5 percent if the employees contribute 5 percent of their salary. To date, the idea seems to be working because the company has a 90 percent participation rate, and the employees—whose average age is 46—average $150,000 in their accounts.
Clay Shaw, vice president of human resources for ProAssurance, says tax benefits are the major reasons workers contribute 5 percent of their salary.
“It’s the before-tax deduction that makes a big difference,” Shaw says. “You can save more money iin the 401(k) plan] than it feels like is coming out of your paycheck.”
But two proposals that would fundamentally alter the tax structure of defined contribution plans are getting lots of attention in Washington. Plan sponsors like ProAssurance and other industry experts say changing tax benefits would hurt the retirement system more than it would help.
“The rules have always allowed employers’ and employees’ contributions to be sheltered from taxation,” says Jack VanDerhei, research director for the Employee Benefit Research Institute in Washington, D.C. “These proposals flip this for everybody.”
The proposals are being considered as ways to reduce the federal deficit. The first proposal would end existing tax deductions for 401(k) contributions and earnings.
Currently, employer and employee contributions and investment earnings on traditional 401(k) accounts aren’t taxed until the employee withdraws money. The deductions would be replaced with a flat-rate credit that would be deposited into workers’ 401(k) accounts.
Employer and employee contributions would be taxed, and that would help the federal government’s bottom line. The Washington, D.C.-based Brookings Institution estimates this proposal would save $450 billion over the next 10 years.
The second proposal—known as the “20/20 cap”—would limit employer and employee annual contributions to 401(k) accounts to $20,000 or 20 percent of a worker’s salary—whichever is reached first. Under the same circumstances, current law caps employer and employee contributions at $49,000 or 100 percent of a worker’s salary.
Proponents of the first idea say the flat-rate credit distributes the tax advantage evenly to all workers. The Urban Institute and Brookings Institution Tax Policy Center in the distrcit notes that two-thirds of the current tax incentives in retirement plans go to workers in the top income quintile. The proposal would help low- and middle-income workers, who are the least likely to participate in 401(k) plans, save more for retirement.
“We think it addresses the tax inequities of the system and is worth a lot of consideration,” says Karen Friedman, executive vice president and policy director for the Pension Rights Center in Washington, D.C. “Even though millions of dollars are used to encourage retirement savings, you still have pretty dismal statistics.”
Friedman says that while the Pension Rights Center is in favor of the proposals, it would like to see those benefits returned to the retirement system, and not reducing the federal deficit. She also adds that the center would be in favor of the 20/20 cap considering how few low- and middle-income earners maximize their annual contribution rate.
But many employers don’t like either tax restructuring idea, a November survey from Principal Financial Group showed. Of the 1,305 plan sponsors from small and medium-sized companies surveyed, 75 percent said current tax deferral incentives are the most important retirement plan feature. Plus, 65 percent who currently offer a plan and 36 percent who don’t said they wouldn’t be as interested in offering a plan that had no tax incentives.
Two-thirds of the respondents predicted employee contribution levels would drop with a 20/20 cap.
“This is a clear message from employers saying preserve tax benefits and consider expanding them,” says Greg Burrows, senior vice president of retirement and investor services in Principal’s Des Moines, Iowa headquarters.
Limiting contributions to $20,000 or 20 percent of salary would hurt many older workers who might not have started to save early and need to make larger contributions toward the end of their working years, says Chris Braccio, vice president of human resources for American Systems in Chantilly, Virginia.
“This is a short-term strategy to build revenue today,” Braccio says. “I’m not sure how we’d encourage people to at least maintain the position they have today.”
Meanwhile, both ideas would likely result in lower account balances for 401(k) participants, according to a November Employee Benefit Research Institute study of the proposals.
By eliminating the current tax deductions, the average reduction for 401(k) plan participants at normal Social Security retirement age would range from a low of 11.2 percent in the highest income groups to a high of 24.2 percent in the lowest income groups for workers ages 26 to 35.
The 20/20 cap would affect high-wage earners the most, but low-wage earners had the second highest percentage reductions in retirement contributions, the EBRI found. If the cap started next year, the average percentage reduction in account balances would range from 15.1 percent for highly paid workers ages 36 to 45 to 8.6 percent for highly paid workers ages 56 to 65.
“Some people simply can’t afford to make a contribution with after-tax dollars,” VanDerhei says. “The only thing that’s working for many people is the defined contribution system.”
Patty Kujawa is a freelance writer based in Milwaukee. To comment, email firstname.lastname@example.org.