Washington Targets Retirement Tax Breaks

BOSTON ( TheStreet) -- Amid a backdrop of deficit concerns, debate over the future of Social Security and Medicare and a looming government shutdown, tax deferrals for retirement plans could be on the chopping block.

Talk in Washington, spearheaded by Congressional leaders including Speaker of the House John Boehner, R-Ohio, and Senate Budget Committee Chairman Kent Conrad, D-N.D., is that tax reform needs to tackle so-called tax expenditures. These incentives, which account for roughly $1 trillion in bypassed budget revenue each year, have been described by Conrad as a "back-door way of spending federal money."

House Speaker John Boehner, an Ohio Republican, is spearheading talks about tax reform that could affect tax incentives for retirement plan contributions.

Among these tax expenditures are exclusions for such items as mortgage interest deductions and employer contributions for health care.

The deferral of taxes on contributions to IRAs, 401(k) plans, variable annuities and other retirement savings vehicles are among the incentives that could be reduced or eliminated. Typically, contributions to these accounts grow tax free until they are withdrawn at retirement, then are taxed at what is usually a lower rate post-retirement.

Retirement-tied tax incentives will cost the government about $142 billion in forgone tax revenue this year and about $788 billion over the next five years. The value of the incentives is challenged by critics who claim 80% of the benefits are claimed by the top 20% of income earners.

Testifying before the U.S. Senate Budget Committee on March 9, Robert Greenstein, president of nonpartisan research organization the Center on Budget and Policy Priorities, spoke against the current system of tax expenditures and described the intended incentive for retirement savings as regressive.

"The costs of tax expenditures are large," he said. "In 2010 ... tax expenditures -- both individual and corporate -- amounted to $1.05 trillion. This greatly exceeded the cost of Medicare and Medicaid combined ($719 billion), Social Security ($701 billion), and non-security discretionary programs, which stood at $589 billion, a little over half of the cost of tax expenditures."

"As is the case with the mortgage interest deduction, high-income individuals receive the largest immediate benefit of the exclusion, even though they are the people most likely to save anyway in the absence of a government tax subsidy," he said.

The rich can often "reshuffle" assets to take advantage of tax breaks, rather than by increasing their savings, he said, noting that the Congressional Research Service has reported that "because higher earners would save much of their income even without tax incentives to do so, a substantial share of the revenue lost through the deduction for contributions to retirement plans does not result in a net increase in national saving."

"While tax cuts will always curry more favor with voters than new spending programs, Washington needs to call a truce to using the tax code for social or economic goals," Seth Hodge, president of The Tax Foundation said at that same hearing. "The consequence of trying to micromanage the economy as well as individual citizens' behavior through the tax code is a narrow tax base and unnecessarily high tax rates. These high rates are endangering America's global competitiveness and undermining the nation's long-term economic growth."

Putnam Investments CEO Bob Reynolds doesn't see it that way. During a speech at the Retirement Income Industry Association's 2011 Spring Conference in Chicago, he warned that going after these tax incentives would reduce the motivation to save at a time many Americans already face a shortfall in their retirement savings and lack confidence in their ability to enjoy a secure retirement.

"It would be a terrible policy mistake to curb federal profligacy by undermining incentives for private saving," he said. "America needs to move to solvency not just for the government, but at the household level too."

"With baby boomers now in or approaching retirement, the stakes are much higher than they were 25 years ago," he added. "We have to get budget deficits under control, but we have to do it the right way -- by encouraging savings that fuels investment, business formation and job creation. In the long run, the only tolerable way to overcome our deficit challenge is through economic growth, led by the private sector and fueled by Americans' own savings. Anything that undermines personal and workspace savings also undermines those goals. Congress should dismiss such ideas out of hand."

The Employee Benefit Research Institute, citing data from this year's Retirement Confidence Survey, is also against changes to the status quo and challenges the assertion that mainly the well-off benefit.

Jack VanDerhei, EBRI's research director, says these proposals would have "unintended consequences "

"Instead of reducing the contribution levels of those with larger taxable incomes, and hence higher marginal tax rates, the RCS results indicate that workers with low levels of household income would be most likely to cut their contribution -- in some cases completely," he says.

The survey found that more than three-quarters of full-time workers with household income of $15,000 to $25,000 say that having the ability to deduct their contributions to retirement savings plans is "very important." More than half of full-time workers saving for retirement said they would reduce the amount they save if they were no longer able to deduct retirement savings plan contributions from taxable income.

Among full-time workers who said they have less than $1,000 saved for retirement, 71.3 % indicated they would reduce the amount they save. Only 22% of full-time workers saving for retirement with household incomes of $100,000 or more say they would cut back.

States are also looking to boost their diminishing budgets by eyeing retirement-related tax changes. Michigan legislators, for example, are debating a proposal to levy a 4.25% income tax on pensions and 401(k) and IRA income.

-- Written by Joe Mont in Boston.

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