Making Maximum Use of Tax-Deferred Retirement Accounts

The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

Note: This report is available in its entirety in the Portable Document Format (PDF).

The text below is a portion of the complete document.

INTRODUCTION

In the past quarter century, defined contribution plans have grown rapidly and are now replacing traditional defined benefit plans as the primary retirement savings instrument for most American workers. This change has shifted greater responsibility for retirement saving from employers to individuals. Future benefits from these accounts depend on the level of contributions from participants (and their employers) during their wage-earning years.

Under Section 401 (k) of the Internal Revenue Code, enacted in 1978, employer and employee contributions to tax-deferred retirement accounts are excluded from wages subject to the income tax, although employee contributions are included in the base for payroll taxes.¹ Earnings within the accounts are tax-free, but withdrawals in the form of lump-sum payments or annuity payments are taxable. In the Economic Growth and Tax Relief Reconciliation Act of 2001, Congress raised the maximum allowable contributions to defined contribution plans and proposals for further increases will likely remain on the legislative agenda. The report of the President's Advisory Panel on Federal Tax Reform (2005) proposes no changes in maximum contributions to employer-sponsored plans, but greatly expands and simplifies provisions that allow individuals to deposit funds in tax-exempt individual saving plans.

Previous studies have shown that most employees contribute less than the legal maximum to employer-sponsored plans. This paper examines changes between 1990 and 2003 in the share of workers in different demographic groups who contribute the legal maximum. Using administrative data on employee contributions to employer-sponsored plans, combined with demographic data on individuals, we find that the percentage of employees who contribute the maximum allowed amounts to plans has increased between 1990 and 2003, but that this increase has been largest among those earnings and demographic groups with the highest shares of maximum contributors. We reach roughly similar conclusions about trends in shares of large contributors, defined as those who contribute either 10 percent of earnings or the maximum amount. The results in this paper reinforce earlier findings that increases in the maximum allowable contribution may have little effect on retirement security for most workers.

The first section of this paper describes the limitations on contributions to employer-sponsored plans and how they have evolved over time. We begin by describing how statutory contribution limits are set and how they have evolved over time. We then review recent literature on the factors that influence employee contributions to salary reduction plans and display summary data on the shares of employees who were offered and participated in employer-sponsored plans in 1992, 1996, and 2001. We then describe the data used in this paper and present data that show how shares of workers who contribute the statutory maximum to defined contribution plans have increased over time for different earnings and demographic groups. For the same groups, we also display changes in the percentages of large contributors (as defined above). Finally, we estimate a number of logit models that explain the probability of contributing the statutory maximum and the probability of contributing at least 10 percent of annual earnings or the statutory maximum and how that probability has evolved over time. A brief concluding section reviews the findings.

Notes from this section of the report

1 Similar provisions for tax-deferred accounts for employees of nonprofit institutions are included in Section 403(b) of the Internal Revenue Code. We will refer to all the plans as tax-deferred retirement accounts. These include the following type plans: cash or deferred arrangements (section 401(k) plans); Thrift Savings Plan for federal employees; salary reduction simplified employee pension plans (SARSEP); savings incentive match plans for employees (SIMPLE plans); tax-sheltered annuity plans (403(b) plans); section 501(c)(18)(D) plans; and section 457 plans.

Note: This report is available in its entirety in the Portable Document Format (PDF).

Usage and reprints: Most publications may be downloaded free of charge from the web site and may be used and copies made for research, academic, policy or other non-commercial purposes. Proper attribution is required. Posting UI research papers on other websites is permitted subject to prior approval from the Urban Institute—contact [email protected].

If you are unable to access or print the PDF document please contact us or call the Publications Office at (202) 261-5687.

Disclaimer: The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders. Copyright of the written materials contained within the Urban Institute website is owned or controlled by the Urban Institute.