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The Shrinking Tax Preference for Pension Savings: An Analysis of Income Tax Changes, 1985-2007

Gary T. Burtless, Eric Toder
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Document date: March 29, 2010
Released online: May 19, 2010

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The value of the tax preference for pensions depends on the marginal tax schedule and on the tax treatment of income from assets held outside a pension account. We find that changes in U.S. tax law, especially the reduction in tax rates on capital gains and dividends, but also the decline in marginal tax rates, have led to sizeable changes in the value of the pension tax preference. On balance the value of the pension tax preference to worker-savers is modestly lower than it was in the mid-1980s and substantially lower than it was in the late 1980s.


THE FEDERAL INCOME TAX encourages saving in qualified retirement saving accounts by exempting from current tax the income accrued within these accounts. In addition, for most qualified retirement plans taxation of labor earnings contributed to the plan is deferred until the benefits are paid out in retirement. Workers who expect to be in a lower tax bracket when retired than when employed thus derive a second important advantage from saving in a qualified plan. For the less-common Roth or prepaid retirement plans, workers deposit after-tax instead of pretax dollars in accounts, but pay no additional tax upon withdrawal. The tax law provides a wide variety of qualified retirement saving plans for individual workers, for the self-employed, and for employees in firms that provide retirement plans to their workers.

The value of the tax preference for qualified plans compared with other investments depends on the marginal income tax rate a worker owes on ordinary income at various stages of the life cycle and the rules for taxing capital income received outside a qualified account. Because marginal income tax rates and the tax treatment of different forms of capital income have varied over time, the value of the tax preference for qualified retirement plans has varied as well. For example, tax law changes enacted in 2001 and 2003 increased the tax preference for long-term capital gains, provided a new tax preference for qualified dividends, and lowered marginal tax rates on ordinary income. Each of these changes reduced the benefit from saving in qualified retirement plans by increasing the relative after-tax return on savings accumulated outside of qualified plans.

This paper examines the change in the value of pension tax incentives per dollar of investment for representative workers. The calculations are performed from the perspective of workers who contemplate making new contributions into qualified plans. The study estimates the income tax liabilities of workers depending on whether their retirement savings are held inside or outside of qualified plans. We simulate the effects of the changes in the tax code that have occurred in recent years, emphasizing the effects of tax rate changes and shifts in the tax preference available to capital income earned outside of pension accounts. Because the tax benefit for contributing to pensions extends over a number of years, the net tax benefit is discounted and is measured as a percentage of the initial investment.

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Topics/Tags: | Economy/Taxes | Retirement and Older Americans

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