Current tax rules and regulations favoring the use of 401(k) plans over Individual Retirement Accounts impedes the growth of retirement saving wealth for many American workers. Several problems exist:
- Rules restricting IRA contributions and the deductibility of IRA contributions will often reduce retirement wealth.
- Automatic enrollment in 401(k) plans regardless of whether the plan matches contributions, vesting requirements, or has high fees will result in suboptimal levels of retirement wealth. The lack of automatic rollovers from high-fee 401(k) plans to low-cost IRAs further erodes retirement wealth for many 401(k) investors.
This post discusses how current rules governing IRAs and 401(k) plans impede household wealth formation and discuss changes to current rules.
Impacts of restrictions on IRA contributions and deductions
Rules limiting IRA contributions, or the deductibility of IRA contributions have a much larger impact on retirement wealth than many people realize.
Restriction One Contribution Limits: The IRA contribution limits for 2024 are $7,000 and an additional catch-up contribution of $1,000 for workers who are 50 or over. The 401(k) contribution limits for employee in 2024 are $23,000 and an additional $7,500 for people who are 50 or over. The total employee and employer 401(k) contribution limits in 2024 are $69,000 and an additional contribution of $7,500 for people 50 or over.
Impacts of Contribution Limits:
- The lower IRA contribution limits create a large disadvantage for workers saving for retirement who lack access to a firm-sponsored retirement plan. This includes the growing number of workers in the gig economy.
- The existence of a higher 401(k) contribution limit will encourage some workers with higher income to contribute to a 401(k) plan even if the plan has high fees and does not match employee contributions.
Restriction Two Deductibility Limits: The deductibility of contributions to an IRA is limited if an individual or spouse of an individual is covered by a retirement plan at work and income exceeds certain levels. By contrast, all contributions to 401(k) IRAs are excluded from taxable income, regardless of the level of the person’s income.
The IRS code limits eligibility for a tax deduction on an IRA for people covered by a retirement plan at work as described here.
The cutoffs for total elimination of the IRA tax deduction for people covered by a retirement plan at work are MAGI of $83,000 for filing status single, $136,00 for filing married joint returns and $10,000 for married filing separate returns for people covered by a retirement plan at work. Note the low cutoff for married people filing separate returns.
The existence of a spouse covered by a retirement plan at work also impacts a worker’s access to a deductible IRA as described here.
The cutoffs for total elimination of IRA deductibility for a person with a spouse covered by a retirement plan at work are $228,000 for married filing joint returns and $10,000 for married filing separate returns. Again, note the low cutoff for married people filing separate returns.
Impacts of Deductibility Limits:
- This rule appears to impede deductibility of IRA contributions for people making job transitions during a year. A person who starts a year at job contributing to a 401(k) plan who moves to a firm without a plan might not make subsequent deductible contributions to an IRA if income was too high. Similarly, a person who contributes to an IRA and then moves to a firm with a 401(k) plan could, depending on income, lose the ability to deduct previous IRA contributions by contributing to a 401(k). A loss of deductions from a previous contribution to an IRA could incentivize the worker to delay all contributions to the 401(k) plan until the next year.
- The limit on the deductibility of IRA contributions prevents people from maximizing employer contributions to their 401(k) plan and placing additional contributions into a deductible IRA, even if the firm 401(k) plan has high fees and contributions not receiving a 401(k) match earn subpar returns.
- A substantial number of relatively young married people are forced to file separate returns to take advantage of Income Driven Replacement Loans. The $10,000 limit on deductibility of IRA contributions will prevent all deductible IRA contributions by young married households without a 401(k) plan.
- This provision will substantially reduce retirement savings for the lower-paid spouse in a divorce. Even though the annual deductibility limits for workers filing joint returns are high, this provision will impact some people who have high annual incomes for some year but lower levels of lifetime earnings due to changes in marital status.
Restriction Three: Restrictions on spousal IRAs: The tax law allows spouses who do not work outside of the home to fund their own IRA when the combined household income is greater than the amount contributed to the spousal IRA. However, non-working spouses cannot contribute to a spousal IRA unless they file joint returns.
Impact of restriction on spousal IRAs:
- The lack of access to a spousal IRA for married households filing separate returns could be extremely detrimental to any spouse that goes through a divorce and ends up with low levels of lifetime earnings and retirement wealth.
- Many adults not working outside the home filing separate returns to take advantage of IDR loans will be unable to save for retirement through a tax-deferred retirement account because of this rule.
Restriction Four: Income limits on Roth contributions Tax rules described here limit contributions to Roth IRAs by high income individuals. Again, the restrictions are especially restrictive for married couples filing separate returns.
Impact of income restriction on Roth contributions:
- There is a workaround to this restriction, the backdoor Roth IRA. All people, regardless of income, are allowed to contribute to a non-deductible IRA and immediately convert the funds in the non-deductible IRA to a Roth, thereby, creating a Roth account without paying any additional tax or penalty. Many people are unaware of the advantages of this procedure. Also, Congress frequently considers abolishing backdoor IRAs to raise revenue.
Impact of other incentives
The tax code allows employers to contribute funds to a 401(k) plan in addition to the employee contribution but does not allow for employers to match worker contributions to an IRA.
The Secure Act 2.0, described here, mandates automatic enrollment of new workers in 401(k) plans even when the worker would be better off using an IRA or pursuing some other financial goal like aggressive reduction in debt levels. The initial automatic contribution is set at 3 percent of income with contributions increased by 1 percent per year up to 10 percent of income.
Impacts of Incentives favoring 401(k) plans:
Workers are not given guidance on whether they should enroll in a 401(k) plan, select an IRA, or pursue some other priority. Often the automatic enrollment feature results in 401(k) contributions when investment in an IRA or debt reduction is more appropriate.
- Most workers with access to a 401(k) plan that matches employee contributions should take full advantage of the employer match. However, some workers with high levels of consumer debt or student loans should prioritize debt reduction over retirement savings and even choose to eschew matching contributions. The costs of saving for retirement including higher borrowing costs and additional years of payments on all forms of debt, car loans, student loan, credit cards, mortgages, described here often substantially exceed the addition in retirement wealth from participating in a 401(k) plan at an early age.
- A worker with a 401(k) plan that does not match employer contributions will often be better off with an IRA if the 401(K) plan has high fees. A study by researchers at Yale found that in 16 percent of 401(k) plans fees used up the entire tax advantage associated with investments in 401(k) plans.
- A worker at a 401(k) with high debt levels or very little liquidity should choose a Roth IRA over a 401(k) plan unless the firm has a Roth 401(k) option because the Roth options allow for the use of all contributed funds without tax or penalty at any time.
- A recent New York Times article found that 401(k) plans often increase fees on small plans after the worker departs the firm. Many of these workers see their small accounts entirely drained by fees. To prevent loss of 401(k) funds from high fees workers should with small plans should roll over funds into a low-cost IRA at a brokerage like Vanguard or Fidelity when they switch firms.
Proposed Policy Changes:
The current tax rules and regulations favor the use of 401(k) plans over IRAs, even when the 401(k) plan charges high fees and has inadequate investment options. Two sets of policy changes are needed. The first involves expanding tax preferences for IRAs and removal of impediments to making IRA contributions. The second involves expanding and modifying automatic enrollment rules:
New Tax Preferences:
- Create an overall retirement account contribution limit on total retirement plan contributions, which would replace the separate limits on 401(k) plan and IRA contributions.
- Allow employers to make matching contributions to IRAs in addition to matching contributions to 401(k) plans.
- Eliminate all limitations on deductible IRA contributions for workers covered with a 401(k) plan or with a spouse covered by a 401(k) plan.
- Eliminate barriers to deductions and contributions to spousal IRAs imposed on married people filing separate returns.
- Remove the income limit on contributions to Roth or deductible IRAs.
Incentivizing the use of IRAs instead of 401(k) plans:
- Create an automatic enrollment rule mandating contributions to an IRA unless the worker opts out. The rule could either apply to workers without access to a 401(k) plan or supersede the current rule mandating automatic contributions to 401(k) plans.
- Mandate automatic rollover of 401(k) plans to IRAs by departing workers unless workers opt out to keep funds in the 401(k).
- Expand in-service rollover options from 401(k) plans to IRAs.
Concluding Remarks: The current rules governing retirement savings are not working well for many households. The tax code substantially limits tax-deferred retirement savings for people without a retirement plan at work. The limits on deductibility and spousal IRA contributions for married people who file separate returns are especially egregious.
The automatic enrollment rule recently enacted under the Secure Act 2.0, the employer matches for 401(k) plans, and the tax incentives favoring 401(k) plans often result in workers selecting investment vehicles with high fees and low returns.
The most effective and least intrusive way to fix these problems and expand retirement savings for household currently struggling to save involves expanding tax preferences for IRAs and automatically enrolling workers into IRAs instead of 401(k) plans.