Reduce Limits on Contributions to Retirement Plans

Current law allows taxpayers to make contributions to certain types of tax-preferred retirement plans up to a limit that varies depending on the type of plan and the age of the taxpayer. The most common such vehicles are 401(k) plans, which are sponsored by employers, and individual retirement accounts (IRAs), which are maintained by the participants themselves.

Individuals under the age of 50 may contribute up to $16,500 to 401(k) and similar employment-based plans in 2011; participants ages 50 and above are also allowed to make "catch-up" contributions of up to $5,500, enabling them to make as much as $22,000 in total contributions in 2011. In general, those limits apply to contributions to all types of employment-based plans combined. However, contributions to 457(b) plans, available primarily to employees of state and local governments, are subject to a separate limit. As a result, employees who are enrolled in both 401(k) and 457(b) plans can contribute the maximum amount to both plans, thereby allowing some people to make tax-preferred contributions of as much as $44,000 in a single year.

In 2011, IRA contribution limits are $5,000 for those under age 50 and $6,000 for those ages 50 and above. The limits on deductible amounts are phased out above certain income thresholds if either the taxpayer or the taxpayer's spouse is covered by an employment-based plan. Contribution limits for all types of plans are indexed for inflation but increase only in $500 increments.

This option would reduce contribution limits, regardless of a taxpayer's age, to $14,850 for 401(k)-type plans and $4,500 for IRAs. Furthermore, it would suspend the indexing of those limits for five years. Finally, it would require all contributions to employment-based plans-- including 457(b) plans--to be subject to a single combined limit. If implemented, the option would increase revenues by $16 billion from 2012 through 2016 and by $46 billion from 2012 through 2021.

One argument in favor of this option centers on fairness. The tax savings associated with these retirement plans-- particularly the employment-based plans that do not have income restrictions--increase with the participant's income tax rate and the amount of his or her contribution. Thus, a worker in the 15 percent tax bracket defers taxes of 15 cents on each dollar contributed to a 401(k) plan, while an employee in the 35 percent tax bracket defers taxes of 35 cents. That larger tax benefit per dollar saved is enhanced for higher-income taxpayers because they tend to save more. Consequently, the taxpayers who would be most affected by the option are primarily higher-income individuals. The limits on 401(k) contributions affect few taxpayers--only 5 percent of participants in 2003--but of those affected, 64 percent had income in excess of $160,000 that year. The option also would level the playing field between those who currently benefit from higher contribution limits (people ages 50 and over and employees of state and local governments) and those subject to lower limits.

In addition to enhancing fairness, the option would improve economic efficiency. A goal of tax-preferred retirement plans is to increase private saving (although at the cost of some public saving). However, the higher- income individuals who are constrained by the current limits on contributions are most likely to be those who can fund the tax-preferred accounts out of existing savings without responding to the intended incentive to actually save more. Thus, the option would increase public saving--by reducing the deficit--at the cost of very little private saving.

The main argument against this option is that it would reduce the retirement saving of a significant number of people, particularly those who find it difficult to save because of income constraints or family responsibilities.

Although only 5 percent of workers with income under would adversely affect those ages 50 and over who might $80,000 in 2003 contributed to IRAs, more than 40 per-have failed to save enough for a comfortable retirement cent of those people contributed the maximum amount while raising their families. The amount they could permitted. Those workers generally have relatively little contribute to tax-preferred retirement accounts would be in accumulated savings and are more likely to respond cut at precisely the time when reduced family obligations to the incentive to save than are people in higher-income and impending retirement make them more likely to groups. Eliminating the catch-up contribution limits respond to tax incentives to save more.