The Savers' Credit: Expanding Retirement Savings for Middle- and Lower-Income Americans

For decades, the U.S. tax code has provided preferential tax treatment to employer-provided pensions, 401(k)-type plans, and Individual Retirement Accounts (IRAs) relative to other forms of savings. The effectiveness of this system of subsidies remains a subject of controversy. Despite the accumulation of vast amounts of wealth in pension accounts, concerns persist about the ability of the pension system to raise private and national savings, and in particular to improve savings among those households most in danger of inadequately preparing for retirement.

Many of the major concerns stem, at least in part, from the traditional form of the tax preference for pensions. Pension contributions and earnings on those contributions are treated more favorably for tax purposes than other compensation: they are excludible (or deductible) from income until distributed from the plan, which typically occurs years if not decades after the contribution is made. The value of this favorable tax treatment depends on the taxpayer’s marginal tax rate: the subsidies are worth more to households with higher marginal tax rates, and less to households with lower marginal rates. The pension tax subsidies, therefore, are problematic in two important respects:

• First, they reflect a mismatch between subsidy and need. The tax preferences are worth the least to lower-income families, and thus provide minimal incentives to those households who most need to save more to provide for basic needs in retirement. Instead the tax preferences give the strongest incentives to higher-income households, who, research indicates, are the least likely to need additional savings to achieve an adequate living standard in retirement.
• Second, as a strategy for promoting national savings, the subsidies are poorly targeted. Higher-income households are disproportionately likely to respond to the incentives by shifting existing assets from taxable to taxpreferred accounts. To the extent such shifting occurs, the net result is that the retirement savings plans serve as a tax shelter, rather than as a vehicle to increase savings, so the loss of government revenue does not correspond to an increase in private savings. In contrast, middle- and lower-income households, if they participate in retirement savings plans, are most likely to use the accounts to raise net savings. Because middle-income households are much less likely to have other assets to shift into tax-preferred accounts, any deposits they make to tax-preferred accounts are more likely to represent new savings rather than asset shifting.

The Saver’s Credit, enacted in 2001, was expressly designed to address these problems. The Saver’s Credit in effect provides a government matching contribution, in the form of a nonrefundable tax credit, for voluntary individual contributions to 401(k)-type plans, IRAs, and similar retirement savings arrangements. Like traditional retirement savings plan subsidies, the Saver’s Credit currently provides no benefit for households that owe no federal income tax. However, for households that owe income tax, the effective match rate in the Saver’s Credit is higher for those with lower income, the opposite of the incentive structure created by traditional pension tax preferences.

The Saver’s Credit is the first and so far only major federal legislation directly targeted at promoting tax-qualified retirement savings for middleand lower-income workers. Although this is an important step, several options are available to improve the design, not the least of which is the credit’s scheduled expiration at the end of 2006.

Policymakers, including Representatives Rob Portman (R-OH) and Benjamin Cardin (D-MD), are exploring possible expansions of the Saver’s Credit. Rep. Portman recently emphasized his desire to “get at what I think is the biggest potential for saving in this country, and that is those who are at modest and low income levels.” This paper is intended to inform such efforts.

The first section of the paper provides background on the evolution and design of the Saver’s Credit. The second section discusses the rationale behind the Saver’s Credit and the role of such a credit in the retirement income security system as a whole. The third section examines empirical data and models of the revenue and distributional effects of the Saver’s Credit. The fourth section discusses measures that would expand the scope and improve the efficacy of the Saver’s Credit.

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