Art by J. CiardialloThe current system of taxation of retirement savings is totally misunderstood. Not just by regular Americans—by most policymakers and experts. In addition, because the explicit tax benefit (the non-taxation of trust earnings) is linked to a vast, obscure and impenetrable set of nondiscrimination rules, it is impossible to figure out who gets the benefits provided by this system and how much those benefits are. Moreover—and no one can disagree with this—it rewards individuals who need no incentive to save and punishes those who can’t. Other than that, it’s a great system.
In this column I just want to focus on that last point—that the current system punishes those who cannot save. How is that?
Oversimplifying somewhat, under the nondiscrimination rules, in order to provide tax benefits to high-rate taxpayers, employers must provide benefits to low-paid employees. This is true for every tax-qualified plan, but let’s just illustrate this by looking at 401(k) plans.
401(k) plans are subject to the (by now famous) actual deferral percentage (ADP) test, under which the amount that highly compensated employees (HCEs) can contribute is dependent on the amount that non-highly compensated employees (NHCEs) contribute. Employers use various devices, including, e.g., “giving” low-paid employees qualified non-elective contributions (QNECs) and qualified matching contributions (QMACs) to boost low-paid employees’ ADPs. Just to be clear about what’s happening here, the employer is basically writing checks to these low-paid employees, not because of anything the low-paid employee has done, but to make it possible (under the ADP test) for highly paid employees to make 401(k) contributions out of their own pockets.
Another thing employers do, in this regard, is jawbone low-paid employees about the importance of making contributions to the plan. Indeed, we just recently got an FAQ from Department of Labor (DOL) explaining that this very thing (providing information “about the benefits of increasing plan contributions in order to maximize the employer match”) was “OK”—that it didn’t make the person advising the participant to increase contributions a fiduciary.
The reasons that employers have to work so hard at getting low-paid employees to make 401(k) contributions are: (1) Low-paid employees generally don’t pay any income tax or, more to the point, any investment tax (e.g., capital gains taxes), so for them there is no tax benefit to contributing to the plan. And (2) (and in my humble opinion more significantly), generally, low-paid employees would, for perfectly sound reasons, prefer cash now to a retirement benefit in 30 years.
But the law, in its infinite wisdom, “thinks” that these low-paid employees should actually be saving for retirement—even if they would rather use this money, e.g., to pay their rent or get some tutoring for their kid. And so, in addition to providing all these incentives for employers to provide retirement benefits to low-paid employees, the Tax Code also includes a punishment—a 10% “early distribution tax”—if the low-paid employee (or indeed any plan participant) takes her money out of the plan in cash, rather than leaving it in until retirement. NEXT: Considering the early distribution tax