How the Income Tax Treatment of Saving and Social Security Benefits May Affect Boomers' Retirement Incomes

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Abstract

Income tax provisions affect the buildup of retirement assets during workers' careers and after-tax income following retirement. This paper uses the Urban Institute's DYNASIM model to simulate how potential changes in the tax treatment of retirement saving, Social Security benefits, and income from assets outside retirement accounts may affect boomers' retirement incomes. Changes in the income thresholds for taxing Social Security benefits have the largest impact on middle-income boomers, while changes in contribution limits for retirement saving plans and tax rates on capital gains and dividends have the largest impact on the highest-income boomers.

Introduction

Tax policy directly affects the amount of wealth individuals can accumulate during their working years and, for a given amount of wealth, the living standards they can enjoy in retirement. Traditionally, Social Security benefits, tax-favored defined benefit plans and retirement saving accounts, and savings accumulated outside tax-favored accounts have been viewed as the “threelegged stool” of sources of retirement income. How tax policies evolve in the future will affect retirement income from all three sources.

Recent tax changes have affected the second and third sources of retirement income. Tax changes enacted in 2001 and made permanent in 2006 expanded access to and increased the amounts people can contribute to tax-preferred individual retirement accounts and employersponsored retirement saving plans. Tax changes enacted in 2003 and extended in 2005 reduced tax rates on capital gains and dividends through the end of 2010, thereby increasing after-tax returns outside tax-favored retirement saving accounts. Tax provisions affecting the treatment of Social Security benefits have not changed since 1993, but the share of Social Security benefits included in taxable income is continually increasing under current law because the threshold levels for inclusion of benefits in income are not indexed for inflation.

This study uses a microsimulation model of individuals’ lifetime earnings, pensions, and nonpension assets, both actual and projected, to simulate the effects of potential tax policy changes on the retirement income of boomer cohorts. The simulations take account of the two ways that tax policy can affect retirement—by changing accruals of wealth in the years before retiring and by changing the taxation of income following retirement. Changes in the tax treatment of saving, both inside and outside tax-favored accounts, affect the rate of wealth accumulation before retirement and the after-tax income that wealth produces following retirement. In contrast, taxation of Social Security benefits affects only after-tax income in retirement. The effective tax rate on Social Security benefits does, however, depend on income from other sources and therefore is also affected by policy changes that affect the pre-retirement buildup of assets.

Previous analyses of the distributional effects of income tax provisions, including tax incentives for retirement, examine how they affect a cross-section of the taxpayer population in a given year. (See, for example, Burman et al. 2006.) While these studies show, for example, how tax law changes benefit people of different incomes in different years, they do not show how the law changes affect wealth accumulation of individuals in the same cohort with different lifetime incomes or different future retirement incomes. In contrast, this study examines how changes in income tax rules that remain in place over a number of years will affect the distribution of aftertax income of boomers at retirement.

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Disclaimer: The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.