Current Tax Treatment Benefits Employees Across Income Scale

Peter J. Brady is a senior economist in the retirement and investor research division at the Investment Company Institute, focusing on pensions, retirement savings, and the taxation of capital income.

In a new book, Brady highlights the importance of tax considerations in projecting retirement wealth, especially when it comes to setting state and national policy.

“Policy discussions of tax deferral often focus on the reduction in taxes enjoyed by workers and ignore the higher taxes these workers will pay during retirement,” Brady explains. The front-end tax deferrals and tax-free growth in defined contribution (DC) plans obviously benefits employees, but it’s important to remember there is a difference between a tax deferral and a pure tax write off.

Considering the impact of taxes paid during retirement on total lifetime income, Brady argues tax deferral affects “when taxes are paid more than it affects the total amount of taxes paid over a lifetime,” a trend most apparent in higher-paid workers analyzed in the study. “For these workers,” Brady explains, “increased taxes during retirement offset, in present value, more than half of the reduction in taxes enjoyed while working.”

For those lower on the income scale, Brady highlights the fact that Social Security is “the primary component of the U.S. retirement system, and the benefits of the Social Security system are proportionately higher for workers with lower lifetime earnings.” Brady adds that, “contrary to conventional wisdom, the marginal benefits of tax deferral (the benefits of deferring an additional $1 of compensation) are higher, on average, for the lower-earning workers analyzed in this study than they are for the higher earning workers. Although the lower earners face lower marginal tax rates while working, their marginal benefits are higher because they experience the largest drop in marginal tax rates during retirement.”

NEXT: Approaches to benefit all 

Brady goes on to suggest the incentive to save in DC plans under the current tax code is not “upside down,” as some like to suggest.  

“Normal income tax treatment discourages savings by taxing investment returns,” he says. “Far from providing an ‘upside-down’ incentive to save, tax deferral equalizes the incentive to save by effectively taxing investment returns at a zero rate for all workers.”

Brady’s argument continues: “If a comprehensive reform of the federal income tax is undertaken, it is important that policymakers consider how all the changes included in any proposed reform would affect the progressivity of the overall tax system. The effect of specific tax provisions on progressivity should not be a concern. Tax provisions that address legitimate policy goals can be included in a reformed income tax even if they are not, by themselves, progressive.”

Brady concludes the justification for a progressive tax rate schedule “rests largely on the assumption that annual income is a reasonable proxy for a taxpayer’s economic circumstances, but the unevenness of earnings over an individual’s lifetime makes this assumption problematic.” Few, if any, of the federal-level tax reform proposals to surface in recent years earn high marks from this perspective, he adds.

Additional findings and more information about Brady’s upcoming book (January 2016) are presented in an ICI whitepaper, online here.