Barry’s Pickings: Is the 401(k) System Unfair? What Would Make It Fairer?

Michael Barry, president of O3 Plan Advisory Services LLC, debates whether the 401(k) system is fair or unfair and offers three ideas for making the system more just.

Art by Joe Ciardiello

Art by Joe Ciardiello

In my last column, I noted that former Vice President Joe Biden’s campaign website attacks what it views as the unfairness of the current 401(k) system, asserting that “two-thirds of the [401(k)] benefit goes to the wealthiest 20% of families” and promising to “equalize saving incentives for middle-class workers … by [e]qualizing the tax benefits of defined contribution [DC] plans … across the income scale, so that low- and middle-income workers will also get a tax break when they put money away for retirement.”

In this column I’d like to discuss whether the current system is in fact “unfair” and, if it is, what might be done about it.

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Is the Current System “Unfair?”

I thought about illustrating with numbers how and for whom the current system produces tax (and non-tax) benefits. But I quickly concluded that the issues were so complex—there are so many variables—that doing so would (for all) be an intensely frustrating exercise.

So, let’s just begin with some propositions about the current system that may give us a general idea of its fairness, or unfairness. (In all of what follows I’m going to ignore Roth contributions.)

  1. Yes, as the Biden website observes, the 401(k) tax exclusion produces a bigger “sticker” tax benefit for high-income/high-margin taxpayers, because their income tax rate and thus their tax savings (on contribution) is greater. But distributions are also taxed at ordinary income tax rates. Assuming the high earner pays the same tax rate at distribution as on contribution, the ultimate tax benefit high earners get has little to do with their income tax rate. Rather, what they save is the taxes on investment income that they would have paid if they had saved outside a tax-qualified plan.
  2. What the investment income tax on non-tax-qualified savings might be is very assumption-dependent, but we can at least observe that the tax rates on long-term capital gains and dividends (the most obvious alternatives) are lower and less progressive than income taxes, tending to decrease the actual unfairness of the current exclusion-on-contribution taxation-on-distribution regime.
  3. 401(k) plans also permit taxpayers with volatile incomes to “income smooth”—to shift income from a high tax year to a low tax year. This is more an issue of fundamental tax policy than of retirement policy. But for middle class taxpayers—because, given the 401(k) dollar limits, that is who we are talking about—is it “unfair” to give earners with volatile incomes a way to smooth out their taxation, in a progressive income tax system?
  4. Some would argue for a principle of tax policy in favor of deductions/exclusions for favored behavior (like tax saving) as a mitigation of progressivity. Put more snarkily: If the progressive tax system didn’t tax highly paid individuals at such high rates, then the 401(k) tax exclusion wouldn’t be so “unfair.” Those who want to increase the current system’s progressivity, of course, view replacing deductions/exclusions with tax credits as a good thing. None of this has anything to do with retirement policy—it’s just pro-progressivity versus anti-progressivity.
  5. Tax Code nondiscrimination rules mitigate the high-income/high-tax-rate bias in the current system, providing valuable non-tax financial benefits (e.g., matching contributions and qualified nonelective contributions) to low-income/low-tax-rate individuals.
  6. Benefits under Social Security are biased (significantly) toward the low-paid. So, in fact, to maintain pre-retirement income, higher-paid individuals are going to have to save more.
  7. In a voluntary, employer-based system, if a plan provides no features attractive to the employer (e.g., in an owner-dominated business) or top management (e.g., in a corporate bureaucracy), many employers simply won’t provide retirement plans.

To be clear: none of this is to say that the current system is fair. Do high-income employees really need an incentive to save? Doesn’t the current system just give them a tax benefit for something they would do in the ordinary course? And, do the tools we’ve developed—(generally) the nondiscrimination rules and (more specifically) the Actual Deferral Percentage (ADP) test, the top-heavy rules, contribution and compensation limits, and minimum distribution requirements—effectively mitigate this “unfairness?”

But talking (nearly exclusively) about “unfairness” in terms of the tax exclusion rate versus a tax credit rate—with no discussion of the taxation of distributions, income smoothing and the nondiscrimination rules—is … kind of disingenuous.

How Big a Problem Is Old-Age Poverty?

If, in making the system “fairer,” our concern is relieving poverty, then consider: Old-age poverty has been lower than non-old-age poverty since the 1990s and has declined 70% in the past 50 years. Nevertheless, problems still exist in certain demographics, e.g., among those 80 and older. (See Poverty Among Americans Aged 65 and Older, July 1, 2019, Congressional Research Service.)

This is not to say that old-age poverty is not a serious problem. But rather that there are other problems of poverty that are more serious.

As I said in my last column, the most likely outcome, if Biden wins, is not (IMHO) a switch to a tax credit system but rather an increase in the Saver’s Credit. I actually don’t think that is a very good idea. Because—and I could be wrong—the problem for poor, working class and lower middle-class individuals/families isn’t that they don’t have incentives to save. It’s that they don’t have the extra income to save, and in fact would have better uses for extra income (if they had it) than saving for retirement.

Our ultimate “fairness” problem is that some individuals and families have (significantly) less resources than others. Many individuals and families simply don’t have the extra income to save. Providing them a tax incentive (tax exclusion or tax credit) for saving for retirement is kind of a sham. You can do it—this is, indeed, more or less what the Saver’s Credit is intended to do. But this isn’t real saving. You’re basically just paying them to save.

How Can We Make the System Fairer?

Here are three ideas:

  • Why not re-allocate some of the “tax expenditures” we are currently expenditure-ing on incentivizing savings—either for (at the high end) the 1% or (at the low end) for individuals who have no extra income to save—to developing a decent and compassionate solution to our growing long-term care problem?
  • As I said above, Social Security does a pretty good job of replacing the pre-retirement income of very-low-income workers. Instead of paying low-paid individuals to save in the 401(k) system, why not improve Social Security income replacement for working-class and lower middle-class individuals/families—those who are not in poverty but are just getting by, who could use some help in retirement in the form of extra income?
  • Finally, rather than paying employers (and, ultimately, providers) to establish plans (e.g., through the small plan startup credit), why not adopt a mandatory employer retirement plan/individual retirement account (IRA) program along the lines of Ways and Means Chairman Richard Neal’s, D-Massachusetts, Automatic Retirement Plan Act? That would be a more effective and cheaper solution to the coverage problem.


I realize much of what I just said may be unpopular. I cannot emphasize enough—on all or any part of the foregoing, I could be wrong. We have a system that—whatever its flaws—is actually working pretty well. The most obvious evidence of that is the amazing decline in old-age poverty we’ve seen in the 401(k) era.

Any changes we make should be incremental. We should do our best to “do no harm.” And we should have explicit metrics for judging the success or failure of any changes we make.

Finally, my bias is to allow individuals to decide what they want to do with their own resources—I believe that (generally) they know better how to save, or spend, their money than do policymakers.


Michael Barry is president of O3 Plan Advisory Services LLC. He has 40 years’ experience in the benefits field, in law and consulting firms, and blogs regularly at about retirement plan and policy issues.

This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Institutional Shareholder Services or its affiliates.