Policy Brief: The Case for Expanding the Use of IRAs Instead of 401(k) Plans

Introduction:

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.  

Some Issues with the SAVE IDR Loan Program

The Biden Administration wants to provide student debt relief by modifying Income Driven Replacement IDR student loans. In my view, IDR loans are costly to taxpayers, difficult to administer, fail to assist many student borrowers in need of assistance, and incentivize some borrowers to take on too much debt.

My preferred approach, which will better target student borrowers in need of assistance at lower cost to taxpayers, involves several modifications to standard and IDR loans and some modifications to the bankruptcy code. This post addresses some general issues on IDR loan payments and some specific issues raised by the Biden Administrations reform efforts.

What determines the choice between an IDR student loan and a traditional student loan?

An IDR loan is the most viable way to prevent default tor many people leaving college with substantial student debt and a relatively modest starting salary.

  • A student borrower leaving college with $25,000 in student debt at a 5.0 percent interest rate would pay $3,182 per year on their student loan.  Total loan payments on an IDR loan that charges 10 percent of disposable income would come to $1,813.

The payment differential between the conventional and IDR loan will change with changes in income and marital status.

Increases in salary increase IDR loan payments which can cause the borrower to shift to a conventional loan.  The decision to convert the IDR loan to a conventional loan ends the possibility of a partial loan discharge.  (It would usually be very foolish for a person to turn down a nice raise at work to remain eligible for a loan discharge).

Increases in household income after marriage will often increase IDR payments and can induce the borrower to shift from IDR loans to conventional loans.  A married IDR borrower can reduce the increase in the student debt payment by filing a separate return but a decision to file separate returns will often result in a substantial increase in tax obligations which, as discussed below, offsets any savings on student loan payments.

When should married couple with an IDR loan file a separate return instead of a joint return?

A married couple where one or both spouses have an IDR loan could reduce their combined student loan payments by choosing filing status married filing separately, but it is highly likely this choice will substantially increase their tax obligations. 

Articles on whether a married couple should file a joint return, or a separate return generally focus steps a taxpayer must take to insulate themselves from their spouses tax liability and the loss of tax deductions and credits.

A larger impact of the decision to choose the file married separately returns stems from a shift in tax deductions towards the spouse with lower income.

  • A married couple making $120,000 filing a joint return taking the standard deduction of $27,700 will pay federal tax of $10,921.    The additional loss of the tax deduction for student loan interest would reduce the couple’s tax obligation to around to $10,371.
  • The same married couple where one spouse makes $40,000 and the other spouse makes $80,000 where each spouse takes the standard deduction of $13,950 will pay a combined household tax of $12,787.

The decision to file separate returns instead of joint returns will for this couple result in an increased tax obligation of $2.408.  The increase in tax obligations may exceed the reduction in student loan payments from the IDR option.

Many newly married student borrowers will immediately switch from an IDR loan to a conventional because of this tradeoff.

What is the potential income of divorce on successfully paying off a student loan under IDR programs.

IDR relief may not be available for a person who switches from an IDR plan to a conventional plan upon marriage and then gets divorced and wants to reenter an IDR program.  A current Biden Administration effort to update and modify IDR loan records, described below, includes a provision that allows for payment credits on IDR loans for payments made under multiple plans.  But this one-time fix may not be available in the future.

Changes in student loan payment obligations caused by changes in income or marital status make IDR loans a risky way to provide student loan debt relief.  The more effective option outlined here involves selective elimination of interest charges at the beginning of a career and upon the maturity of the loan.

Why are so few people getting IDR loans discharged?

Even after accounting for conversions from IDR to conventional loan programs due to changes in income and marital status relatively few student borrowers are obtaining timely debt discharges from IDR loans.  A GAO report found that as of June 1, 2021, only 157 IDR loans had been approved for forgiveness even though another 7,700 loans were potentially eligible for forgiveness.

Both borrower and loan servicer errors result in inaccurate reporting of student loan payments and annual recertifications as documented in this  CFPB report.  One reason why it is difficult to track payment errors is that in some years or months the required payment on the IDR loan is zero, an amount that is indistinguishable from the amount received if the person failed to make a payment on time. 

A failure to annually recertify income and household size can result in loss of IDR payment status.  This document  indicates that applicants under the SAVE program who fail to recertify will be ineligible for a loan discharge while applicants on the PAYE, IBR or ICR plan can remain in the IDR plans, but their payment will be based on the 10-year standard repayment plan.

What can be done to increase on-time IDR discharges?  What are the limits of efforts to improve the administration of IDR loan programs?

There have been several attempts to facilitate IDR discharges by reviewing, modifying, and updating student loan payment records.  Congress passed legislation in 2019 to help facilitate IDR loan discharges.   The Biden Administration announced an IDR review effort in April 2022. The current Biden Administration effort to update and modify IDR loan records adjusts payment counts for forbearances, deferments and payments made under other payment plans.

The Biden Administration has been fairly aggressive about helping IDR loan applicants obtain a loan discharge. Future Administrations may not place a high priority on facilitating student loan discharges, hence IDR loans unlike other loans are impacted by a form of political risk.

Despite these ad-hoc payment count adjustment efforts the number of IDR discharges remains low, and many discharges occur later than stipulated under the contract.  Again, the better solutions outlined here  involves selective elimination of interest charges at the beginning of a career and upon the maturity of the loan.

What are the major changes to the IDR program under the Biden Administration’s SAVE program?  

The major changes announced under the SAVE program listed here include:

  • Increase protected income for loan payments from 150 percent of the federal poverty line (FPL) to 225 percent FPL.
  • No interest charge when the IDR payment is lower than interest due.
  • Allows married borrowers to exclude spouse’s income when filing separately.
  • Disallows existence of spouse in household size calculation when filing married separately.
  • Starting in 2024, cuts payment rate on SAVE loans to 10 percent to 5 percent of disposable income.
  • Links number of years needed to obtain a loan discharge to initial size of the loan balance. Students with loan balances below $12,000 are eligible for a loan discharge at 10 years.  Each additional amount borrowed of $1,000 results in one additional year for eligibility of a discharge up to 20 or 25 years.

Does the SAVE program prevent loan balances from increasing overtime?

The SAVE feature prohibiting interest charges when the SAVE payment is less than the interest charge will prevent an increase in the student loan payment when the borrower makes payments on time.  However, student loan balances could increase if the borrower fails to make payments or if the borrower pauses student loan payments to go back to school.  

Does the SAVE program create an incentive for people with less than $12,000 in debt from going back to school and pursing more education.

The SAVE rules appear to create a disincentive for more education by recipients of a two-year degree with less than $12,000 in student debt.  

The person with up to $12,000 in debt who chooses to stop further education will have the remaining balance on the initial $12,000 in debt forgiven after 10 years, as long as the person makes the payment on the SAVE loan.

The person who goes back to school and formally pauses student debt payments will likely have around $30,000 in total debt upon completion of a bachelor’s degree and no chance for a loan discharge for another 20 years.

It may be possible for a student to maintain payments on the original IDR loan while in school and get a partial discharge of debt after 10 years.  The rules appear ambiguous on this point.  This is a question for the Department of Education.

How does the SAVE option impact student debt payments for a typical Bachelor’s degree recipient? 

The typical bachelor’s degree recipient will end school with around $30,000 in student loans and start her career at a relatively low salary.   The initial payment on the loan, currently 10 percent of adjusted gross income over 225 percent of the federal poverty line, is relatively small and is unlikely to initially cover the interest on the loan.  

The SAVE loan borrower essentially has a zero-interest loan with an unchanged $30,000 balance until the borrower’s salary rises to the point that her payment (defined as 10 percent of the difference between AGI and 225 percent of the FPL) falls below interest charges.

A person who maintains a low-salary and low household income will make modest student loan payments for twenty years and have the loan forgiven assuming the loan payments were correctly reported by the loan servicer.

A student borrower who obtains a higher salary or household income would have to make higher loan payments.  The SAVE loan does not limit the monthly payment on the loan when AGI rises.   Other programs like PAYE and IBR cap the monthly payment at the payment for a 10-year standard loan, but these programs would allow the loan balance to increase if the loan payment did not cover interest costs.  

Dave Ramsey has noted that many IDR borrowers could pay more on their student loan than the borrower with a standard 10-year loan both because payments could persist for 20 to 25 years and could rise substantially with income.

Is debt forgiven under IDR programs taxable?

The American Rescue Plan exempted dischargeable student debt from federal tax for debt discharged prior to December 2025.  However, some states treat dischargeable student loans as taxable income.

Authors Note:  A newly published SSRN paper examines the impact of both additional education and additional student debt on the ability of households to make a $400 emergency payment.

Reducing Student Debt Burdens

Introduction:

The Biden Administration, to its credit, has tried to reduce burdens caused by record levels of student debt. However, the Administration’s preferred solutions have been blocked and some of the on-going and newly implemented programs appear ineffective.

  • The Supreme Court blocked a one-time discharge due to COVID.
  • The payment shock from the termination of the COVID-era student loan payment freeze will reduce consumer spending and could facilitate a recession.
  • The Biden Administration proposal for expanded Income-Driven loans is complex and less effective than interest rate reductions.
  • Low levels of on-time graduation remain an important factor in high student debt burdens.
  • Many student borrowers leaving school prior to the completion of a degree have a difficult time repaying their student loans.

The objective of this post is to provide and explain potential economically efficient solutions to these problems.

Student Debt Proposals:

Proposal One:  Issue an executive order setting the interest rate on all student loans at 0 percent for the first two years of the loan. The proposed reset of interest rates will be both less costly to taxpayers and more effective to student borrowers than the SAVE IDR loan program currently implemented by the Administration.

Analysis

  • The executive order would be challenged in the courts but a potential court challenge did not prevent the Biden Administration from implementing the SAVE IDR program through executive order.
  • Delinquencies would fall at the beginning of careers when workers tend to have lower salaries.
  • A lower interest rate and quicker repayment of loans would allow young workers to increase household savings, a necessary prerequisite for many Social Security reform proposals under consideration.
  • Quicker repayment of student loans by young adults should eventually reduce the number of older adults with unpaid student loan balances in retirement
  • An initial interest rate of 0 percent would reduce demand for Income Driven Replacement (IDR) Loan programs, which will benefit both student borrowers and the Treasury.
  • The proposed elimination of interest rates at the start of the repayment period reduces the number of households who will be unable to obtain any debt relief due to changes in marital status and family income.

Proposal Two: Modify the standard 10-year and 20-year federal student loan contract to eliminate all interest charges at the maturity of the loan. Treat unpaid student loan balances after the maturity of the student loan as a tax obligation spread over 3 to 5 years.

Advantages of proposed changes:

  • The interest rate of zero at the maturity of the loan provides some relief for people who have had difficulty repaying their loan, regardless of whether they initially selected an IDR or conventional loan.
  • This change will reduce the number of people who have their Social Security checks garnished because of outstanding student loan obligations.
  • The proposal creates an incentive for borrowers to select a standard student loan contract instead of an income driven loan contract, which reduce uncertainty associated with IDR loans and could reduce costs to taxpayers.
  • Under the modified student loan contract, the borrower with a larger loan will always repay more than the borrower with the smaller loan over the lifetime of the loan.  By contrast, under the IDR program it is possible an increase in initial student loan debt does not increase the amount repaid over the life of the loan.

Proposal Three:  Modify IDR loan programs to provide for gradual partial discharges of student debt instead of a complete discharge of the remaining balance at the maturity of the loan.

  • Discharge formula might involve 10 percent of previous 24 payments after receipt of 24 payments. 
  • Limit discharge at the maturity of the loan to 50 percent of the outstanding balance.
  • Undischarged loan balance will be restructured into a new short-term low interest rate loan and perhaps be treated as a tax liability.

Advantages of proposed changes to IDR contracts:

  • The quicker partial discharge gives borrowers an incentive to make payments on time to maximize debt relief.
  • The quicker partial discharge reveals potential problems with the recording of loan payments earlier.  Currently, payment problems are not revealed until maturity when the borrower apples for the complete loan discharge, leading to a delay or even in a denial of the loan discharge.
  • The limitation of the final discharge to 50 percent of the outstanding loan balance will cause borrowers with larger loans to have a higher debt at maturity than borrowers with lower debt, reducing the tendency for borrowers to increase the amount they borrow in anticipation of a complete discharge.  

Go here for a discussion of the Biden Administration’s IDR reform effort.

Proposal Four:  Provide greater financial assistance to all first-year students with the goal of eliminating all student debt incurred during the first year of post-secondary school education.

Analysis:  Increasingly, some education after high school is necessary for career advancement.  Many student borrowers who leave school prior to the completion of the degree have great difficulty in repaying their loans.  Increased financial assistance for first-year students will increase access to higher education for underserved groups and will assist people likely to have the most difficult repaying loans.

Proposed changes to first-year financial assistance programs:

  • Provide federal or private tax-preferred grants to institutions that agree to eliminate student debt incurred by first-year students.
  • All state and private institutions that agree to match the new federal/private funds are eligible for the new grants.
  • Participating institutions are not allowed to provide federal student loans to first-year students.
  • Benefit is available at both two-year and four-year institutions.
  • Additional benefits could be provided to students transferring from a two-year to four-year institution.

Advantages:

  • Program reduces payment problems and default rates by student borrowers that leave college early prior to the completion of their degree.  (Students leaving college without a degree after only one or two years of study tend to have an especially hard time repaying their student loan.)
  • Program will reduce typical college debt levels.
  • Absence of debt could allow a person to reenter school later in life when she is more prepared for higher education.
  • Proposed goal of a debt-free first year of post-secondary education is far less expensive than previous free college or debt-free colleges proposals. 
  • Program allows more highly qualified people to consider a four-year college and would reduce the number of students who believe a two-year school is the only option. 
  • Prospect of additional assistance for transfer students could further reduce costs for students who start their post-secondary career at a two-year college and mitigate impact of credits lost through the transfer process.

Proposal Five:  Modify the bankruptcy code to allow for the discharge of private student debt in bankruptcy and to provide priority to federal student debt payments over all consumer loans in chapter 13 bankruptcy plans.

Analysis:  Student debt has always been difficult to discharge in bankruptcy.  The 2005 Bankruptcy reform law discouraged Chapter 7 bankruptcy in favor of Chapter 13 and made it more difficult to discharge private student loans in bankruptcy.  Moreover, in most instances current law results in higher priority for consumer debt over all student loan debt in Chapter 13 bankruptcy plans.  Some student borrowers now leave chapter 13 bankruptcy plans with more student debt than when they entered.  More favorable treatment of student debt in bankruptcy could benefit both student borrowers and taxpayers.

 Proposed Changes:

  • Retain current rules governing access to Chapter 7 and Chapter 13 bankruptcy adopted in the 2005 Bankruptcy reform act.
  • Change bankruptcy code to make private student loan debt dischargeable in bankruptcy.
  • Provide priority to payments on federal student loan payments under chapter 13 bankruptcy plans.

Advantages

  • Retention of means test for use of chapter 7 bankruptcy discourages bankruptcy filings for many people who might be able to pay off their debts without bankruptcy relief.
  • Private student loans with high interest rates is similar to credit card debt and other consumer loans and should be treated accordingly.
  • Helps people leaving chapter 13 bankruptcy obtain a fresh start.
  • Helps taxpayers by increasing and speeding up student debt payments.  
  • Helps the most vulnerable student borrowers.  Should reduce the number of older taxpayers having Social Security garnished because of unpaid student debt.
  • Creates an incentive for lenders to better evaluate the ability of borrowers to repay private consumer loans and private student debt.