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Tax the Rich – and Limit Retirement Contributions? It Doesn’t Add Up.

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Tax the rich!  Raise their rates! Limit their deductions! That seems to be the populist mantra. It’s perpetuated in the press, and there’s some indication that the general public seems to support the idea. Now middle class workers with higher than average incomes seem to be caught up in discussions defining those that are “rich.”

As this applies to tax-exempt organizations, we’re talking about hospital administrators, educators, executive directors of local community and other charitable organizations – people who generally earn a better than average income, yet by no stretch of the imagination do their incomes compare to Warren Buffett’s. And when it comes to the impact on their employers’ retirement plans, shouldn’t the tax structure support retirement readiness for those who have dedicated their careers to giving back to their communities?

For example, current conventional belief supports that people should be saving 11-15% of their pay, including matching contributions, every year throughout their working careers in order to save enough to be retirement ready(1)(2). Assuming a 3% match, and therefore an average of a 12% annual savings need, anyone earning less than approximately $146,000 annually should be fine.  (12% of $146,000 is approximately the $17,500 annual limit.)

However, what about the person making $250,000 per year? Contributing a maximum of $17,500 only equates to 7% of pay. When the match is included it’s still short of the target necessary for retirement readiness—yet as the numbers show, these limitations currently in place put these people at a disadvantage for retirement savings. In addition, one of the alternatives under consideration is limiting qualified plan contributions even further.

Fortunately, there is something that can be done. Private (non-governmental) tax-exempt organizations can maintain a deferred compensation plan under section 457 of the internal revenue code. These 457 plans allow for additional benefits for a select group of management or highly compensated individuals, over and above the limitations in their 403(b) or 401(k) plan.

457 plans are an excellent tool for tax-exempt organizations to be able to recruit, retain, reward and retire key personnel. In other words, they help meet the goals of the organization (which in turn, serves their communities) while empowering key employees to meet their financial goals.

For additional insight, check out this video by John Baergen that provides a primer on 457 plans.

Last summer, Senator Tom Harkin released a report called “The Retirement Crisis and a Plan to Solve It.”  One premise of the report is that there is inadequate savings for Baby Boomers and Gen Xers to pay for basic expenses in retirement. The report footnotes studies that show this ”retirement income gap” is between $4.3 and $6.6 trillion, but as we see above, there is already pressure in regular tax rules that make it difficult for higher-than-average income people to achieve retirement readiness.

As Congress continues the tax debate, it’s important that we consider what’s good for the long term, and helping all plan participants achieve retirement readiness should be of paramount importance. Tax reform and retirement policy should not be at odds. 

In addition to blogging here, I also tweet regularly about topics of interest to Tax Exempt plans. Follow me on Twitter: @1aaronfriedman1.

Click here to follow my Tax Exempt blog

Research with Financial Advisors, June 2011, conducted by Harris Interactive on behalf of the Principal Financial Group®.

(2) Our View on Retirement Readiness: How to Move from a “Popular” Plan to a Successful Plan, the Principal Financial Group, September 2011. The estimate assumes a 40-year span of accumulating savings, as well as the following facts: Retirement at age 65; Social Security providing 40% replacement of income; annual market returns of 7%; annual inflation of 2.5%; annual wage growth of 3.5% over 40 years in workforce. This estimate is based on a goal of replacing 85% of salary. The assumed rate of return for the study was hypothetical and does not guarantee any future returns nor represent the return of any particular investment. Contributions do not take into account the impact of taxes on pre-tax distributions.

Affiliation Disclosures

While this communication may be used to promote or market a transaction or an idea that is discussed in the publication, it is intended to provide general information about the subject matter covered and is provided with the understanding that none of the member companies of The Principal are rendering legal, accounting, or tax advice. It is not a marketed opinion and may not be used to avoid penalties under the Internal Revenue Code. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.

Insurance products and plan administrative services are provided by Principal Life Insurance Company.  Securities are offered through Princor Financial Services Corporation, 1-800-547-7754, Member SIPC and/or independent broker dealers.  Securities sold by a Princor® Registered Representative are offered through Princor.  Princor and Principal Life are members of the Principal Financial Group® (The Principal®), Des Moines, IA 50392.

© 2013 Principal Financial Services, Inc.

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4 Comments Post a comment
  1. Andrew Martin #

    The person making $250k simply saves the additional money needed to reach a 11%-15% target OUTSIDE of a qualified plan. What’s the problem? It’s not like they are forced to spend the money instead.

    January 28, 2013
    • Aaron Friedman, National Practice Leader - Tax-Exempt, the Principal Financial Group, Princor Registered Representative #

      Good point. But the same thing could really be said about savers at any income level. Our national policy has been to encourage savings with tax deferral and consider we’re not really talking about truly wealthy people here. Just high income middle class. There are already large pressures on these folks. In my example, we’re talking about people contributing to the good of their communities.

      January 29, 2013
      • Andrew Martin #

        I just don’t see this as anywhere near the biggest problem we have with our lack of national savings or our national retirement policy. You’ve already mentioned that a 457 could be made available for these folk. Often a DB SERP is in place for an oh-BTW long-ago frozen or terminated DB plan. if neither, they can save on their own without a tax subsidy. I am more concerned about the average Janes and Joes, and how they are supposed to retire. The folks you mention will be fine under any scenario.

        January 29, 2013
      • Aaron Friedman, National Practice Leader - Tax-Exempt, the Principal Financial Group, Princor Registered Representative #

        I don’t disagree with the priority. Retirement readiness for all is where we should be putting our efforts, and the tax debate distracts from that objective.

        January 29, 2013

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