401(k) plans

We have talked a bit about how personal finance and saving for retirement is hard. One reason that 401(k) plans have been able to charge high fees (management fees plus fees from the individuals mutual funds) is that they are tax free savings vehicles (and tax free covers a lot of sins). That is now being openly discussed:

The tax break for defined contribution retirement plans will cost the Treasury $212.2 billion between 2010 and 2014, according to the Joint Tax Committee. But the vast amount of that benefit - as much as 80 percent - goes to the top 20 percent of earners, according to estimates from the Tax Policy Center, a nonpartisan, but liberal-leaning, think tank.

For example, a person in the 35 percent tax bracket saves $35 in taxes every time he puts $100 in his 401(k), for a net cost of $65. Someone in the 15 percent bracket pays $85, after tax, for the same $100 contribution. The Pension Rights Center, which has favored traditional defined benefit pensions and other programs aimed at lower-income retirees, advocates rolling back the current $16,500 annual 401(k) tax-deferred contribution limit to the $10,500 level it was at before the Bush tax cuts, its director, Karen Ferguson, has said.

One way to address both the cost and the disparity is to change the deduction into a credit. William Gale, of the Brookings Institution, will present a plan like that to the Senate committee on Thursday. His plan would eliminate the deduction entirely and replace it with a federal match that would be deposited directly into workers retirement accounts. A match of 30 percent would be revenue neutral, he says.

Neither solution is ideal. Lowering the deduction limit makes these plans less able (even in theory) to store enough wealth for retirement. It also makes "catching up" after a period of unemployment or education more difficult.

Matches, on the other hand, are much easier to cut than tax breaks. Dropping the match from 30% to 28% is an easy cut that raises a lot of revenue. It may be harder to penalize post-tax withdrawals, which runs the risk of funds being emptied due to an unexpected job loss.

None of this would really matter if we were confident that social security would be around. It really is the key government anti-poverty program. But ponzi scheme comments are not helping build confidence in the long term health of the program.