These are limits that are adjusted for inflation, after all – designed to help retirement savings (and benefits) keep pace with increases in the cost of living. In other words, if today you could only defer on a pre-tax basis that same $7,000 that highly compensated workers were permitted in 1986 – well, let’s just say that you’d lose a lot of purchasing power in retirement.
But since industry surveys suggest that “only” about 9%-12% currently contribute to the maximum levels, one might well wonder if raising the current limits matters. Indeed, one of the comments you hear frequently from those who want to do away with the current retirement system is that the tax incentives for 401(k)s are “upside down,” that they go primarily to those at higher income levels, who perhaps don’t need the encouragement to save. Certainly from a pure financial economics perspective, those who pay taxes at higher rates might reasonably be seen as receiving a greater benefit from the deferral of those taxes.
Drawing on the actual account balance data from the EBRI/ICI 401(k) database, and specifically focusing on workers in their 60s (broken down by tenure and salary), the nonpartisan Employee Benefit Research Institute has found that those ratios were relatively steady. In fact, those ratios are relatively flat for salaries between $30,000 and $100,000, before dropping substantially for those with salaries in excess of $100,000. (See chart.) In other words, while higher-income individuals have higher account balances, those balances are in rough proportion to their incomes – and not “upside down.”
And yet, according to Vanguard’s How America Saves 2017, only about a third of workers making more than $100,000 a year maxed out their contributions. If these limits and incentives work only to the advantage of the rich, why aren’t more maxing out?
Arguably, what keeps these potential disparities in check is the series of limits and nondiscrimination test requirements: the boundaries established by Internal Revenue Code Sections 402(g) and 415(c), combined with ADP and ACP nondiscrimination tests. Those plan constraints were, of course, specifically designed (and refined) over time to do just that – to maintain a certain parity between highly compensated and non-highly compensated workers in the benefits available from these programs. The data suggest they are having exactly that impact.
Those who look only at the external contribution dollar limits of the current tax incentives generally gloss over the reality of the benefit/contribution limits and nondiscrimination test requirements at play inside the plan – and yet surely those limits are working to “bound in” the contributions of individuals who would surely like to put more aside, if the combination of laws and limits allowed.
One need only look back to the impact that the Tax Reform Act of 1986 had on retirement plan formation following the imposition of strict and significantly lower contribution limits – as well as a dramatic reduction in the rate of cost-of-living adjustments to those limits – to appreciate the relief that came in 2001 with EGTRRA.
Anyone who has ever had a conversation with a business owner – particularly a small business owner – about establishing or maintaining a workplace retirement plan knows how important it is that those decision-makers have “skin in the game.”
While we don’t yet know what the limits for 2018 will be, gradually increasing the limits of these programs to keep pace with inflation helps assure that these programs will be retained and supported by those who, as a result, continue to have a shared interest in their success.
And that’s good news for all of us.
- Nevin E. Adams, JD
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