What’s the Tax Advantage of 401(k)s?

Tax reform is high on the nation’s agenda. While Re­publicans and Democrats may disagree about the ex­tent to which tax increases should be part of the defi­cit reduction effort, they generally agree that a broader base and lower rates for the federal income tax would promote fairness and boost economic growth. The base-broadening discussion inevitably raises the question of cutting back on some “tax expenditures.” These expenditures are revenue losses attributable to provisions of the tax laws that are designed to support particular activities. Prime examples are the provi­sions designed to encourage retirement savings. It seems like a good time to understand the nature of these expenditures, determine how the revenue losses are calculated, think about how tax reform could affect the value of these provisions, and speculate how changes might affect participation and contributions in tax-advantaged savings vehicles, particularly 401(k) plans. The discussion proceeds as follows. The first section provides a brief overview of the role of taxes in the evolution of employer-sponsored retirement plans. The second section describes the tax advantage associated with 401(k) plans. The third section dis­cusses the magnitude of the 401(k) tax expenditure. The fourth section highlights how the size of the tax expenditure depends on the tax treatment of capital income outside of 401(k)s. The fifth section discusses the potential impact of proposals to cut back on the 401(k) tax expenditure. The final section concludes that while some reform proposals may make the 401(k) tax expenditure more equitable, policymakers should proceed with caution because the employer-based retirement system is the main savings vehicle for American workers.