Tax-deferred 401(k) plans good news for workers

Tax-deferred 401(k) plans may be a better deal for low-income workers than economists thought, according to new research by my Tax Policy Center colleague Eric Toder and Urban Institute senior research associate Karen Smith.

While high-income workers may get a bigger tax break from their 401(k)s, they also face a short-term trade-off. That’s because their employers tend to offset their contributions to these plans by paying them less in wages. But Eric and Karen found while lower-wage workers get less of a tax benefit than their higher-paid colleagues, their wages fall by much less for every dollar their employer contributes to their retirement plan.

Until now, economists assumed salaries of low-wage workers fully offset employer payments to their (k) plans. But Eric and Karen found that may not be true for lower-wage workers. Thus, while they enjoy both their employer’s contribution and a modest tax reduction, their employer doesn’t reduce their cash wages to fully offset those benefits. Bottom line: Total pre-tax compensation for low-wage workers who participate in 401(k)s increases while it remains about the same for those making more money, who get all their benefits from tax-savings.

To understand what’s happening, think about this phenomenon in two pieces. First, the tax break:  An employee’s contribution to her 401(k) plan is tax deferred. She pays no tax upfront on wages that she contributes, but  is taxed when she withdraws the money after she retires. Usually, though, she’ll be paying tax at a lower rate since her income in retirement is likely to be lower.

Most important, she gets to earn money tax-free within the retirement plan. And that can be a big benefit.

However, the ability to exclude both contributions and earnings from income is much more valuable to someone in the 35 percent bracket than to a co-worker in, say, the 15 percent bracket.

The second part of the story is what happens to wages. The traditional theory has been that a dollar of fringe benefits (such as a retirement plan or health insurance) reduces wages by a dollar, leaving total compensation unchanged.

But by matching workers’ earnings histories to their retirement plan contributions and other fringe benefits as well as other worker charateristics, Eric and Karen found that wages for low-income workers hold up much better than those of high-earners when their employers increase their contributions to (k) plans.

And sometimes, the difference is dramatic. For example, if an employer increases its contribution by $1 for workers already in a plan, that extra benefit replaces only 11 cents of wages for a low-income woman but 99 cents if she is in a high-income family.

Why the difference? Eric and Karen figure it’s because many low-income workers benefit less from a dollar their employer contributes to their retirement plan than from an extra dollar of cash wages and thus place less of a value on their 401(k). For instance, their own contributions reduce their ability to pay for ordinary living expenses, employer contributions cut their future Social Security benefits (since they don’t count in Social Security benefit calculations) and, because they are in relatively low tax brackets, they gain little from their ability to defer tax on their earnings.

Eric and Karen acknowledge their results are preliminary. But their results tell policymakers that encouraging people to contribute more to to their 401(k)s could increase the total compensation of low-wage workers. And that’s an important message.