The Hidden Entitlements

12. Pensions, IRAs, etc.

Normally, people don't get a tax deduction for the money they save. (If they did, we'd have a consumption tax, not an income tax.) But employer contributions to pension plans and certain other kinds of personal retirement savings are excluded from individuals' adjusted gross incomes. Likewise, investment income earned by pension funds and other qualifying retirement plans is not taxed when earned. Instead, people pay tax on their retirement savings and accrued investment income only when they withdraw the funds after retirement.

Tax breaks for employer-pension contributions were first established as an incentive for corporations to provide pensions to their workers. Similar treatment was later extended to unincorporated businesses and later to Individual Retirement Accounts for people without employer-provided pensions. (In 1981,eligibility for tax-deductible IRAs was granted even to workers with pensions,but that expanded IRA tax break was scaled back in 1986).

To further the goal of assuring that pension benefits are not limited to business owners, managers and highly-paid employees, "anti-discrimination"rules have been gradually strengthened over time. These rules are supposed to assure that pension benefits go to the , too.

In general under current law, pension contributions or benefits must be based on an equal percentage of salary for all eligible workers (up to the maximum contribution of $30,000 a year). Full-time workers must gain a full right to accrued pension benefits (i.e., benefits must "vest")after five years on the job, or alternatively, benefits can vest at 20%a year from the third to the seventh year of work.

Notwithstanding these and many other salutary albeit complex rules, many employers do their best to tilt their pension benefits in favor of highly-paid workers, especially in non-unionized industries and small businesses. That practice comes on top of an intrinsic tilt in pension tax breaks: the fact that their value depends on a worker's marginal tax rate--the "upside-down"effect common to most personal tax subsidies. Top-bracket taxpayers benefit from tax deferral at about a 40% tax rate, while most workers defer tax at about a 30% rate on the initial employer contributions (counting income and payroll taxes) and at a 15% rate on the pension fund's investment earnings.

Although pension tax deferrals clearly favor the well-off in terms of their direct tax benefits, pension tax breaks have probably helped enhance retirement savings for ordinary workers (if only by encouraging workers to negotiate with their employers to take part of their pay in pensions rather than current compensation). In fact, the distribution of pension payouts to retired people is actually far more even than the distribution of income overall. For example, families with incomes below $50,000 have 40% of total income from all sources, but get 50% of total pension income.In contrast, people making more than $200,000 get 16% of the nation's total income, but only 5% of total pensions.

Retirement savings tax breaks, particularly IRAs, have sometimes been touted as "savings incentives." Yet despite a major expansion in the use of these tax subsidies over time, national savings has not improved.Indeed, the abject failure of IRAs to augment savings (along with their skyrocketing cost) was one reason IRAs were scaled back in the 1986 Tax Reform Act.21 Unfortunately, both President Clinton and congressional Republicans have proposed to undo much of the 1986 IRA reforms by restoring IRA eligibility to better-off families with employer pensions.


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