Art by J. CiardialloThe current system of taxation of retirement savings is totally misunderstood. Not just by regular Americans—by most policymakers and experts. In addition, because the explicit tax benefit (the non-taxation of trust earnings) is linked to a vast, obscure and impenetrable set of nondiscrimination rules, it is impossible to figure out who gets the benefits provided by this system and how much those benefits are. Moreover—and no one can disagree with this—it rewards individuals who need no incentive to save and punishes those who can’t. Other than that, it’s a great system.

In this column I just want to focus on that last point—that the current system punishes those who cannot save. How is that?

Oversimplifying somewhat, under the nondiscrimination rules, in order to provide tax benefits to high-rate taxpayers, employers must provide benefits to low-paid employees. This is true for every tax-qualified plan, but let’s just illustrate this by looking at 401(k) plans.

401(k) plans are subject to the (by now famous) actual deferral percentage (ADP) test, under which the amount that highly compensated employees (HCEs) can contribute is dependent on the amount that non-highly compensated employees (NHCEs) contribute. Employers use various devices, including, e.g., “giving” low-paid employees qualified non-elective contributions (QNECs) and qualified matching contributions (QMACs) to boost low-paid employees’ ADPs. Just to be clear about what’s happening here, the employer is basically writing checks to these low-paid employees, not because of anything the low-paid employee has done, but to make it possible (under the ADP test) for highly paid employees to make 401(k) contributions out of their own pockets.

Another thing employers do, in this regard, is jawbone low-paid employees about the importance of making contributions to the plan. Indeed, we just recently got an FAQ from Department of Labor (DOL) explaining that this very thing (providing information “about the benefits of increasing plan contributions in order to maximize the employer match”) was “OK”—that it didn’t make the person advising the participant to increase contributions a fiduciary.

The reasons that employers have to work so hard at getting low-paid employees to make 401(k) contributions are: (1) Low-paid employees generally don’t pay any income tax or, more to the point, any investment tax (e.g., capital gains taxes), so for them there is no tax benefit to contributing to the plan. And (2) (and in my humble opinion more significantly), generally, low-paid employees would, for perfectly sound reasons, prefer cash now to a retirement benefit in 30 years.

But the law, in its infinite wisdom, “thinks” that these low-paid employees should actually be saving for retirement—even if they would rather use this money, e.g., to pay their rent or get some tutoring for their kid. And so, in addition to providing all these incentives for employers to provide retirement benefits to low-paid employees, the Tax Code also includes a punishment—a 10% “early distribution tax”—if the low-paid employee (or indeed any plan participant) takes her money out of the plan in cash, rather than leaving it in until retirement.

Think about that for a second. Younger, low-paid employees change jobs a lot. And at job-change, they often (usually?) take their 401(k) account, including all those QNECs and QMACs and their own contributions that they were encouraged to make and any vested matching contributions, and simply cash it out. Most of these employees are among the 44% or 45% who don’t pay any income tax. Except they do pay this one tax—10% of all that money they cash out just goes right to the Treasury. Again, think about it: if their employer had simply given them cash, instead of this very special “tax-favored” retirement benefit, they wouldn’t have paid any tax at all. But because it was given to them as a “retirement benefit,” they do have to pay tax.

That all strikes me as very weird. That 10% tax is there to make sure that money contributed to a 401(k) plan is used for retirement. But everybody knows, when this money goes in, that—for this low-paid group—it’s likely be converted to cash pretty quickly.

Some would say that this 10% tax on early withdrawals is wildly regressive. After all, it’s paid by individuals who otherwise don’t pay any income taxes at all.

But I don’t see it that way. I see it as money spent on these low-paid employees not because of the work they do but simply to capture a tax benefit provided to highly paid employees. I think that these contributions for low-paid employees are ultimately funded out of reductions in the pay of the highly paid. There is some research to support that understanding (see, Do Low-Income Workers Benefit From 401(K) Plans? by Eric Toder and Karen E. Smith of the Urban Institute), but it’s pretty speculative. If this theory sounds crazy to you, read that article.

How much money are we talking about? The only data point I have is from a 2009 GAO report, "401(k) PLANS: Policy Changes Could Reduce the Long-term Effects of Leakage on Workers’ Retirement Savings," which quoted Internal Revenue Service (IRS) as saying that “5 million tax filers paid $4.6 billion in early withdrawal penalties in tax year 2006.” How big is that number today?

If you believe in the current system (personally, I am becoming disillusioned with it), then it seems to me the right thing to do here is to just let these low-paid employees take the cash and get rid of this 10% tax. Unless you think you know better what they should do with this money than they do—in which case, you should simply prohibit any cash outs and mandate that this money stay in the system. Good luck persuading low-paid employees to contribute anything to a 401(k) plan if you take the latter approach.

All of this—in my humble opinion—points up how irrational our current system is. Let me be clear here: I’m not saying the system is “unfair” or “favors the rich” or has “upside down incentives.” It just doesn’t make any sense. Which—given that it lacks all transparency—is not really very surprising.

Michael Barry is president of the Plan Advisory Services Group, a consulting group that helps financial services­ corporations with the regulatory issues facing their plan sponsor clients. He has 40 years’ experience in the benefits field, in law and consulting firms, and blogs regularly http://moneyvstime.com/ about retirement plan and policy issues.