Further Limit Annual Contributions to Retirement Plans

Background

Current law allows taxpayers to make contributions to certain types of tax-preferred retirement plans, up to a maximum annual amount that varies depending on the type of plan and the age of the taxpayer. The most common such plans are defined contribution plans (any plan that does not guarantee a particular benefit amount upon retirement) and individual retirement accounts (IRAs). Defined contribution plans are sponsored by employers. Some—most commonly, 401(k) plans—accept contributions by employees; others are funded entirely by the employer. IRAs are established and funded by the participants themselves.

Most of the tax savings associated with retirement plans arise because the investment income that accrues in the account is either explicitly or effectively exempt from taxation. That is clearest in the case of Roth retirement plans—both IRAs and 401(k)s. Contributions to such plans cannot be excluded from taxable income; instead, the participant benefits by not paying tax on the investment income, either as it accrues or when it is withdrawn. More traditional types of tax-preferred retirement plans allow participants to exclude contributions from their taxable income and defer the payment of taxes until they withdraw funds. If the taxpayer is subject to the same tax rate that applied when contributions were made, the value of the deduction is offset by the tax on withdrawals. The actual tax benefit is equivalent to that provided by Roth plans—effectively exempting investment income from taxation. (In the traditional structure, however, the tax benefit can be higher or lower than under a Roth plan, depending on the difference between the participant's tax bracket at the time contributions are made and when withdrawals are made.)

The value of the tax exemption for investment earnings increases with the participant's income tax rate. Thus, an employee in the 12 percent tax bracket saves 12 cents on each dollar of investment income accrued in his or her retirement plan; however, an employee in the 35 percent tax bracket avoids taxes equal to 35 cents per dollar of investment income. (For some forms of investment income, such as capital gains, lower tax rates apply in each tax bracket, and the savings are smaller.)

People under the age of 50 may contribute up to $18,500 to 401(k) and similar employment-based plans in 2018; participants ages 50 and above are also allowed to make "catch-up" contributions of up to $6,000, enabling them to make as much as $24,500 in total contributions in 2018. In general, the limits on a person's contributions apply to all defined contribution plans combined. However, contributions to 457(b) plans, which are available primarily to employees of state and local governments, are subject to a separate limit. As a result, employees enrolled in both 401(k) and 457(b) plans can contribute the maximum amount to both plans; in 2018, some people's tax-preferred contributions can thus total as much as $49,000. Employers may also contribute to their workers' defined contribution plans, up to a maximum of $55,000 per person in 2018, less any contributions made by the employee.

In 2018, combined contributions to Roth and traditional IRAs are limited to $5,500 for taxpayers under the age of 50 and $6,500 for those ages 50 and above. The tax deduction for contributions to a traditional IRA is phased out above certain income thresholds if either the taxpayer or the taxpayer's spouse is covered by an employment-based plan (but nondeductible contributions—which still enable a taxpayer to defer taxes on investment gains until they are withdrawn—are allowable at any income level). Allowable contributions to Roth IRAs are phased out above certain income levels, and no contributions are permitted at incomes above $199,000 for married taxpayers who file joint returns, $10,000 for married taxpayers who file separate returns, or $135,000 for unmarried taxpayers. However, participants can circumvent those limits by making a nondeductible contribution to a traditional IRA and then converting the traditional IRA to a Roth IRA before any investment income can accrue. (The first use of such a conversion creates a tax liability on amounts already in the traditional IRA, but once those preexisting amounts are taxed, conversions of subsequent nondeductible contributions are tax-free.) Annual contribution limits for all types of plans are adjusted, or indexed, to include the effects of inflation, but only in $500 increments (increments of $1,000 in the case of the overall limit on contributions to defined contribution plans).

The Internal Revenue Service reported that 52 million individuals contributed to 401(k)-type plans in calendar year 2014, 8 percent of whom made the maximum allowable contribution. More recent information is available for IRAs: In 2015, almost 11 million individuals contributed to IRAs—40 percent of those to traditional IRAs and 60 percent to Roth IRAs. Of those contributing to traditional IRAs, 47 percent made the maximum allowable contribution, according to the Congressional Budget Office's estimates. Of those contributing to Roth IRAs, 34 percent contributed the maximum amount. Contributions to retirement plans generally increase with personal income, but the contribution limits increase only with inflation. Thus, the share of participants making the maximum allowable contribution tends to increase over time.

Option

Under this option, a participant's maximum allowable contributions would be reduced to $16,500 per year for 401(k)-type plans and $5,000 per year for IRAs, regardless of the person's age. The option would also require that all contributions to employment-based plans—including 457(b) plans—be subject to a single combined limit. Total allowable employer and employee contributions to a defined contribution plan would be reduced from $55,000 per year to $50,000. Finally, conversions of traditional IRAs to Roth IRAs would not be permitted for taxpayers whose income is above the top threshold for making Roth contributions.

Effects on the Budget

The lower limits on contribution amounts would increase revenues by $109 billion from 2019 through 2028, the staff of the Joint Committee on Taxation estimates. The constraints on Roth conversions would reduce revenues by $6 billion over that period, for a total increase of $103 billion. Higher estimates in the last three years reflect the expiration of lower individual income tax rates at the end of 2025.

The reduction in revenues associated with constraining Roth conversions largely reflects the loss of tax payments that would otherwise be due at the time existing balances in traditional IRAs were converted. But the longer-term effects on revenues of that aspect of the option would probably be different. The loss of Roth benefits for those above the threshold would result in the taxation of more investment income—whether because the investment income arising from nondeductible contributions would be taxed upon withdrawal from a traditional IRA, or because some individuals would shift their contributions to taxable accounts. Existing balances can be converted only once; thus, the revenues associated with conversions are expected to diminish over time until all participants who wish to convert their balances have done so. Similarly, the revenue loss from disallowing some conversions would also diminish over time. Eventually, the revenues gained by taxing more investment income would probably outweigh those lost from disallowing conversions.

The option would also affect federal outlays, but by much smaller sums. Reducing the amount that employers are allowed to contribute would lead to an increase in taxable wages—the base from which Social Security benefits are calculated—and thus would increase spending for Social Security by a small amount. (The estimates shown here do not account for those additional outlays.) The changes in contributions by employees would not affect the wage base for Social Security.

The estimate for this option is uncertain because it relies on projections and estimates that are uncertain. Specifically, it relies on projections of retirement plan contributions, which are based on CBO's economic projections of the economy over the next decade under current law, and on estimates of how taxpayers would change their saving behavior in response to the change in contribution limits.

Other Effects

One argument in favor of this option centers on fairness. The option would reduce the disparity in tax benefits that exists between higher- and lower-income taxpayers, in two ways. First, taxpayers directly affected by the option would make fewer contributions and accrue less tax-preferred investment income, so the greater benefit of the exemption to those in higher tax brackets would be reduced. Second, the option would affect more higher-income taxpayers than lower-income taxpayers. Although the limits on 401(k) contributions affected only 8 percent of participants in calendar year 2014, 53 percent of those participants had income in excess of $200,000 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.

Also, the option's constraints on Roth conversions would reduce the complexity and improve the transparency of the tax system, making it easier for participants and nonparticipants alike to understand the tax ramifications of Roth accounts. Furthermore, the financial institutions managing the accounts would incur, and pass on to participants, fewer administrative costs. (Even greater transparency could be realized by eliminating the income thresholds and allowing everybody to contribute directly to a Roth IRA, but that would reduce revenues over the long term.)

The main argument against this option is that it would reduce the retirement saving of some lower- and moderate-income people. Eliminating the extra allowance for catch-up contributions in particular would adversely affect those ages 50 and over who might have failed to save enough for a comfortable retirement while raising their families. The amount that they could contribute to tax-preferred retirement accounts would be cut at precisely the time when reduced family obligations and impending retirement make them more likely to respond to tax incentives to save more.

In addition, further limiting total contributions to a defined contribution plan would create an incentive for some small businesses to terminate their plans (or not establish new ones) if the tax benefits to the owners of providing such plans were outweighed by the cost of administering them. To the extent that such plans were terminated, employees would then have to rely on IRAs, which would lead some to save less because of the lower contribution limits.

The net effect of the option on total private saving is uncertain. The majority of participants in tax-preferred plans contribute less than the maximum amount allowed under the option; the option would not affect their incentives to save. Among the remaining participants, however, the option's effects on such incentives would vary. CBO estimates that, overall, the option would reduce incentives to save among a small group of participants—those who contribute less than the current limit but more than the maximum amount allowed under the option. For taxpayers in that situation, each additional dollar saved above the option's limit (up to the current limit) would yield a smaller after-tax return than they would receive under current law. However, only 10 percent of participants in traditional IRAs (and a smaller percentage of participants in other types of plans) fell into that category in 2014. At the opposite end of the saving spectrum are people who currently contribute the maximum allowable amounts to tax-preferred retirement plans and contribute additional amounts to taxable accounts. The option would not reduce their after-tax return on each additional dollar saved because it would be in excess of the limit in either case. However, because the option would make their total after-tax retirement income lower than they currently anticipate, some of those people might choose to put more money in taxable accounts to make up for that loss, thereby increasing their saving. Low- and moderate-income people are more likely to fall into the group that would reduce their saving, whereas high-income people are more likely to fall into the group that would increase their saving, and it is not certain which effect would dominate.