Should Your 401(k) Be Eliminated to Save Social Security Benefits?

Retirement savings are essential for financial security, but data show that many people in the United States lack sufficient funds for retirement. High healthcare costs, living expenses, and inflation make it challenging for many to save enough. Meanwhile, Social Security is facing solvency issues. Without reforms, the latest estimates indicate future generations' benefits could be in jeopardy as early as 2035.

Enter economists Alicia Munnell, director of the Center for Retirement Research at Boston College, and Andrew Biggs, senior fellow at the American Enterprise Institute (AEI). They propose abolishing tax-sheltered savings plans like 401(k)s and IRAs to bolster Social Security. 

Their report, which has stirred controversy, spotlights disparities in retirement savings across income levels and raises questions about the effectiveness of current retirement policies. Here's more of what you need to know.

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What’s wrong with 401(k) plans

Many people see tax-advantaged retirement plans as a useful tool to encourage saving for one's retirement and to provide a financial safety net. (Contributions made to 401(k) plans reduce your taxable income since they are made with pre-tax dollars.) 

Supporters of these plans emphasize the importance of employers offering matching contributions to encourage retirement savings. They also often urge the need to enhance these and other incentives to promote sound financial planning.

An example of this is the SECURE 2.0 Act, massive legislation passed by the U.S. Congress a couple of years ago to encourage more people to save for retirement. SECURE 2.0 significantly changes 401(k), IRA, Roth, and other retirement savings plans.

Critics of tax-advantaged retirement savings plans, like Munnell and Biggs, contend that the current system fails to increase overall retirement savings. 

• First, they argue that retirement savings plan tax subsidies are expensive. The authors cite Treasury data indicating revenue loss (a reduction in federal income taxes) from IRAs and employer-sponsored plans like 401(k)s and IRAs of “about $185-189 billion in 2020.”
• Additionally, Munnell and Biggs contend that tax-favored retirement savings plans disproportionately benefit the wealthy. Those tax revenues, they argue, could benefit retirees through Social Security instead.

“Revenues saved from repealing the retirement saving tax preferences could be reallocated to address the majority of Social Security’s long-term funding gap, strengthening a program that is crucial for the retirement security of older Americans while bypassing a decades-old debate about raising taxes or reducing Social Security benefits.”

Based on the Federal Reserve's data for 2022, households within the top 10% income bracket had an average retirement savings of $1.29 million. However, individuals from the middle class face difficulties in saving enough for retirement, with a median retirement savings of $87,000 in the same year. Additionally, many smaller businesses often require support in providing 401(k) plans, resulting in limited retirement options for their employees.

According to the report, the decline of traditional pensions over the past few decades has worsened the problem. While tax-advantaged accounts benefit those who can contribute, many remain excluded from retirement savings options. 

Munnel and Biggs suggest capping tax benefits for high earners or adjusting contribution limits to ensure tax breaks are more equitable across income levels.

Social Security benefits

Currently, more than 66 million people receive monthly Social Security benefits. Most of the program's income comes from tax revenues, but it is not generating enough revenue now to sustain similar benefit levels in the future.

• On May 7, the Trustees for Social Security and Medicare released its annual report on the status of the various Social Security trust funds. 
• The report estimates that the combined trust funds will be exhausted by 2035. (That’s about a year longer than earlier Congressional Research Service (CRS) projections of when Social Security wouldn’t pay full benefits scheduled under current law.)

According to the Committee for a Responsible Federal Budget, these estimates mean that “Social Security's retirement trust fund will reach insolvency when today’s 58-year-olds reach the normal retirement age and today’s youngest retirees turn 71.”

Meanwhile, aside from eliminating tax-preferred retirement savings plans, numerous proposals to shore up Social Security are floating around. Some suggestions involve raising the retirement age, eliminating taxes on Social Security benefits, and increasing taxes on high earners.

Retirement savings: Bottom line

As the election approaches, lawmakers are expected to evaluate the current retirement system and debate options regarding the financial stability of millions of older adults. However, it's uncertain which proposals will gain enough support in a divided Congress to pass.

If you are worried about your retirement savings, it's good to seek guidance from a reliable and qualified financial or tax planner. Also, keep an eye on any current or upcoming changes in retirement plan rules, like those in the SECURE 2.0 Act.

Related

• Calculating Taxes on Social Security Benefits
• A Proposal to Eliminate Taxes on Social Security Benefits
• SECURE 2.0 Act Changes Retirement Plan Rules
• Hidden Costs and Tax Benefits of HSAs