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New 401(k) Study

Friday, June 8, 2001 at 9:04 AM

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It started in 1978 as paragraph "401" of the Internal Revenue Code. Now 401(k) tax deferred retirement plans total in the billions, and could be growing. Part of President Bush's $1.3 trillion tax cut raises 401(k) retirement plans and similar pension program increases the amount of tax-deferred savings to $15,000 by 2006. But a new study suggests some people would be better off reducing their 401 retirement savings. 90.3's Janet Babin reports.

Janet Babin- Tricia Zakrajsek`s a saver. The 23-year-old account coordinator has been investing in a 401(k) plan for two years, devoting 10% of her salary to the tax-deferred saving plan. She signed up for the retirement plan as soon as possible.

Tricia Zakrajsek- Being so young and right now having a lot of income that I’m able to save, whereas, when we have the kids, we’ll need to spend that extra money on diapers, and other things.

JB- Tricia’s getting married in a few months, and over lunch in a coffee shop downstairs from her office, Trisha talks about seeing a gorgeous dress at a bridal show, thinking it might be “the one.”

TZ- I called this place to see if they had this dress, and the woman said well how much do you want to spend, and I said about $500, and she said well this isn’t the place, ‘cause everything is $2,500 or more.

JB- She ended up buying an off the rack number in her price range.

TZ- I’m think I’m just a practical person. I love my dress, just as much as any other designer dress in a bride magazine.

JB- Tricia’s practicality seems to be paying off. She and her fiance’ already have a house and a financial planner to go along with their 401(k) plans, while most people their age are just getting out of school. If Tricia places her 401(k) money in her company’s stock, it matches her contribution dollar for dollar, making the pretax saving plan seem like a great deal, because deferred wages aren’t subject to income tax withholding when they’re deposited, only at retirement.

But the standby of retirement saving might not be so practical for some savers. A new study suggests that low to moderate income households can actually lose money over a lifetime by saving in a 401(k) plan.

The study was written by a Boston University economics professor, and economist Jagadeesh Gokhale with the Federal Reserve Bank of Cleveland. Gokhale says he was shocked by his findings:

Jagadeesh Gokhale- The expectation is that you save money on a tax free basis and you’re gonna come out ahead, but that’s not necessarily true for some types of individuals, because of the way 401k saving and then withdrawals after you retire interact with the tax system.

JB- Gokhale found that assuming a 6% real return on assets, households earning less than $50,000 per year that invest fully in a typical 401(k) plan actually raise their lifetime taxes.

Gokhale and the other researchers used a personal financial planning model to chart the lifetime tax benefit to theoretical households with varying incomes and family sizes, starting at $50,000 per household. Gokhale says the findings are complicated, but describes them like this: because 401k savings are taken out before income is taxed, it reduces salary, which can change a family from a higher tax bracket to a lower one that qualifies for fewer tax reductions on a home mortgage. Also, the additional income withdrawn from the 401(k) at retirement, can increase the taxes taken out of social security benefits.

JG- Social Security benefit taxation has this peculiar feature that it depends on the sum of a person’s taxable income, plus 50% of benefits. Now that amount will be higher if you’re other taxable income is higher

JB- But Gokhale says that’s not the case in households with higher earnings, because they’re benefits are already taxed in a higher bracket.

JG- Higher earners receive a much larger benefit than low earners. Low earners benefit can be negative if certain conditions are satisfied.

JB- Roughly 40 million Americans invest in 401(k) plans. Based on the latest survey of Consumer Finances conducted by the Federal Reserve Board, of families earning between $25,000 - $50,000, 63% participate in a 401(k) plan. Robert McIntyre of Citizens for Tax Justice says that’s a lot of families who might be negatively impacted by the 401(k) plan designed to help them save money.

Robert McIntyre- People who have money can afford it, but lots of Americans don’t make that much, and saving for retirement anyway is not a high priority when you’re just trying to make sure your family has a roof over their heads and food on the table.

JB- Citizens for Tax Justice supports tax relief for middle to low income families. Gokhale hopes his study will spur Congress to again review tax laws regarding 401k plans. Tricia Zakrajsek makes less than $50,000 now, but when she’s married this September, she and her husband will earn above the $50,000 mark. She hopes the study doesn’t discourage other young people from saving for retirement.

TZ- I don’t think it’s necessarily correct to say don’t contribute. Because I know I don’t have a pension, so if I don’t contribute to that, how do I retire? What do I retire on?

JB- Gokhale hopes so too. He says the study isn’t meant to discourage people from investing. Instead, he wants employees to consider other retirement options. Look for Gokhale’s 401(k) study to appear on the Federal Reserve Bank website within two weeks. In Cleveland, Janet Babin, 90.3 WCPN News.

Additional Information

* Federal Reserve Bank of Cleveland
* Employee Benefits Research Institute
* Internal Revenue Service
* Citizens for Tax Justice

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