Gets wrong...

What Trump gets wrong about 401(k)s

The GOP plan to reform the 401(k) will still hurt the middle class. But not for the reason Trump says.

By DANNY VINIK

The news that Republicans are considering a tight cap on 401(k) contributions, first reported by the New York Times last week, shocked the financial world as lobbyists and analysts alike wondered whether a cornerstone of America’s retirement system could be at risk. President Donald Trump took to Twitter Monday morning to put those fears to rest. “There will be NO change to your 401(k),” he tweeted. “This has always been a great and popular middle class tax break that works, and it stays!”

If you care about increasing Americans’ retirement savings, Trump is right that the GOP proposal to tightly cap 401(k) contributions is a bad idea—but the reason he gives is exactly wrong. The real reason doesn't have all that much to do with the middle class, but is closely connected to why it’s so hard to convince Americans to save for retirement.

The tax break for 401(k)s, under which Americans sock away hundreds of billions of dollars of tax-free retirement savings every year, is seen as a classic middle-class tax break, along with the child tax credit and exclusion for employer-sponsored insurance. It’s not: Contrary to Trump’s tweet, the break does relatively little to help the middle class. In fact, most of the benefits of the tax break, which costs the government more than $100 billion a year, accrue to the rich. The problem with the GOP proposal is not that the rich would continue to disproportionately benefit from the exclusion; the problem is that, from everything we know about modern economics, trimming it would lead to lots of other people, even middle-class workers, saving less for retirement.

Retirement savings plans, though pitched as policy for everyone, aren’t very evenly distributed throughout the income ladder. According to a 2009 survey, most workers in the bottom quarter of the income distribution don’t even have access to workplace retirement benefits. In the top quarter, 73 percent of them do. And the rich are more likely to participate in those plans: 94 percent of high-income workers who have access to workplace retirement benefits use them, compared to just 72 percent of low-income workers. In turn, the rich receive most of the benefits from retirement tax breaks.

“The well-off is who really benefits. In that sense, it’s a really bad tax break,” said Monique Morrissey, an economist at the left-leaning Economic Policy Institute who has researched workplace retirement plans.

The Republican proposal, according to the Times, would lower the maximum annual pre-tax 401(k) contribution from $18,500 to just $2,400. (Workers could still contribute above the $2,400 threshold, but those additional contributions would be taxed initially.) In theory, this change shouldn’t affect savings decisions for many workers, since their post-tax earnings won’t be too different whether they're either taxed now, or, under a traditional 401(k) plan, at the time of withdrawal.

But Brigitte Madrian, an economist at Harvard’s Kennedy School who has extensively studied workplace retirement plans, believes that the House GOP proposal could significantly reduce savings. Her work is part of a new strain of economic research, called behavioral economics, that examines how people actually operate in the real world. She’s found that, for the most part, Americans don’t understand the federal tax system and retirement tax breaks. When choosing how much to save, she said, they don’t take a deep look at their finances, projected retirement expenses and federal tax breaks and work backwards to estimate their optimal savings level. Instead, they effectively use mental tricks to reach a decision, often choosing a round number like 5 or 10 percent. “When you are sitting down and deciding how much to save, there are a lot of possibilities. People don’t have the mental bandwidth to evaluate all those options,” she said. “They reduce the choice to a few options that seem particularly salient.”

Madrian worries that one of those mental shortcuts people could use is the federal cap on 401(k) contributions. Few savers hit the current $18,500 cap, so it’s unlikely that many are currently using that as a target. But if Congress lowered the 401(k) cap to $2,400, millions of workers would hit that limit, and many of them may just stop contributing at that point—perhaps out of simplicity or perhaps because they view the cap as an implicit endorsement of the optimal savings level. Either way, it leads to reduced savings.

“In the middle class, most people just do whatever we’re going to do and figure out whether there’s a tax break for it later,” said Joshua Gotbaum, a guest scholar at the Brookings Institute who served as the head of the federal Pension Benefit Guaranty Corporation from 2010 to 2014.

The upside of Madrian’s research is that American workers care about and understand retirement tax breaks far less than policymakers previously believed, which gives them more bandwidth to reform the system without reducing savings. For instance, Madrian believes that Congress could move the entire 401(k) system to a Roth system, under which savings are taxed initially but can be withdrawn tax-free, without a drop in retirement savings; her research suggests such a change wouldn't affect the real-world retirement choices that most workers consider. In other words, if you were considering saving either 5 or 10 percent of your income under the old system, you'd most likely make the same choices under a Roth system—even though the tax breaks changed substantially. There’s evidence for this as well: A 2014 study found little change in worker savings decisions after employers introduced a Roth plan.