If you change the tax benefits of retirement plan contributions, what impact will that have on retirement savings levels?

This is a key question for employers to ask as the federal government, struggling with spending cuts and tax reform, considers changes to the tax treatment of retirement plan contributions, particularly the level of allowable tax-deferred contributions. Currently, employees can contribute up to $16,500 of their pay on a pre-tax basis, along with a maximum of $5,500 in catch-up contributions for those over age 50. The overall limit for all 401(k) contributions (pre-tax employee and employer contributions, catch-up contributions and after-tax contributions) is the lesser of $49,000 or 100 percent of compensation.

Opponents of these proposals suggest that at least some of these proposed changes would cause individual employees to reduce their retirement plan contributions in response to reduced tax benefits. This, in turn, would reduce overall retirement savings for individual employees. Moreover, some of the evidence supports this conclusion. For example, the Employee Benefit Research Institute (EBRI) 2011 Retirement Confidence Survey found that 56 percent of full-time employees who are currently saving for retirement would reduce their plan contributions if those contributions were no longer deductible from taxable income.

One proposal put forth by William Gale of the Brookings Institution would end pre-tax employee 401(k) contributions and replace them with flat-rate refundable tax credits of 18 percent or 30 percent designed to serve as a matching contribution. In testimony before the Senate Finance Committee, Jack VanDerhei, EBRI research director, noted that such a change would cause individual employees to reduce the contributions they make to their 401(k) plans and, therefore, lead to lower overall retirement savings. He backed up this assertion with modeling results that show the impact this change would have on individuals at different income levels. For example, the model show that individuals age 26-35 in the highest income groups would see their 401(k) accounts reduced by 11.2 percent when they retire, while individuals in the lowest income groups would see their accounts drop by 24.2 percent.

This model found a similar across-the-income-spectrum reduction in overall retirement savings under another proposal included in the deficit reduction report by the National Commission on Fiscal Responsibility and Reform, the so-called Simpson-Bowles Commission. That proposal would cap annual employer plus employee tax-deferred retirement plan contributions at $20,000 or 20 percent of income. when it comes to the average percentage decline in 401(k) plan assets at retirement, the EBRI model showed that the highest-income group and lowest-income group were the most adversely affected In every age group except the oldest employees.