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146 It is now more than a quarter of a century since the Employee Retirement Income Security Act (ERISA) was passed. ERISA regulates employer-sponsored tax-favored vehicles for retirement saving, including defined contribution (DC) pension plans; a key element of the law’s provisions governing DC plans is to limit the amount of tax-deductible contributions. In both nominal and, especially , inflation-adjusted terms, those limits have been tightened over the years. Rules current in 2000 allow workers and their employers to contribute a combined total of 25 percent of a worker’s earnings or $30,000, whichever is less, to a DC plan each year; of that total, the employee can contribute no more than $10,500. 1 For 401(k)–type plans in which the employer makes no contribution, $10,500 becomes the total limit. If the employer does not sponsor any plan, a worker is limited to an annual contribution of $2,000 to an individual retirement account (IRA). 2 Life-Cycle Saving, Limits on Contributions to DC Pension Plans, and Lifetime Tax Benefits jagadeesh gokhale, laurence j. kotlikoff, and mark j. warshawsky 5 We thank Mary DiCarlantonio and Shana Neiditch for research assistance and William Gale, Leslie Papke, Annika Sundén, Peter Weinberg, David Wise, and others for helpful comments. Laurence Kotlikoff thanks the National Institute of Aging for research support. The findings and views expressed in this chapter are those of the authors and not necessarily those of Boston University , the National Bureau of Economic Research, TIAA-CREF, or the Federal Reserve Bank of Cleveland. 1. Internal Revenue Code, sections 415 (c)(1) and 402 (g). 2. Internal Revenue Code, section 408 (a). 05-0238-8 chap5.qxd 3/26/04 9:42 AM Page 146 Lifetime Tax Benefits / Gokhale, Kotlikoff, and Warshawsky 147 In recent years, Congress has raised the limits on tax-deductible contributions to retirement accounts. And it is currently contemplating even further increases in the limits. Policymakers’ interest in the issue is understandable: more and more workers are saving for retirement primarily through DC and IRA plans, and limiting their contributions raises concerns about the adequacy of retirement savings. Those concerns are consistent with the results of studies by Warshawsky and Ameriks (2000), Bernheim, Forni, Gokhale, and Kotlikoff (2000), and others suggesting that many Americans are saving too little to sustain their current standard of living into old age and with the fact that many workers are not covered by pension plans. Would raising the joint employer-employee contribution limit in DC plans increase saving for retirement? Or is the real issue raising the limits on employee or IRA contributions or the limits for older workers—or simply getting employers and employees to set up retirement plans if they do not have one or to increase their contributions if they are contributing less than the allowed maximum ? To encourage full participation in retirement plans, the government does provide a significant tax benefit for most households: contributions are tax deductible. Although withdrawals are taxable, no federal or state tax on capital income accrues before withdrawal. 3 Unlike with saving outside a retirement account, the deferral of tax payments gives workers an interest-free loan on the taxes they otherwise would have paid on the original contribution plus all capital income subsequently earned on the contribution. As a result, the capital income component of income tax is effectively eliminated for income earned and invested in retirement accounts. Because poor and low-income workers are assessed low rates of income tax and have significantly more of their preretirement earnings replaced by Social Security benefits, the DC joint employer-employee contribution limits seem to have been set with middle-, upper-middle-, and high-income groups in mind. The goal of the joint limit appears to be to permit middle- and upper-middleincome households to save significant sums on a tax-favored basis in order to fund a comfortable retirement, while limiting the tax break available to the rich. That approach also limits short-term losses in aggregate tax revenues for the federal government. 4 3. This discussion ignores Roth IRAs. 4. DC contribution limits also constrain the amount of tax arbitrage possible under the system. Tax arbitrage, in this context, refers to borrowing on a tax-deductible basis and using the proceeds to make contributions. Borrowing on a tax-deductible basis means that interest paid on such borrowing is tax deductible. Because, as just indicated, interest earned on funds invested in DC plans is...

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