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Distributional Effects of Defined Contribution Plans and Individual Retirement Accounts

Leonard E. Burman, William G. Gale, Matthew Hall, Peter Orszag

Published: August 19, 2004
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The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

TPC Discussion Paper No. 16

Note: This report is available in its entirety in the Portable Document Format (PDF).


The federal government has subsidized retirement saving relative to other saving since the origins of the income tax in 1913. In 2003, the present value of the federal revenue loss from new contributions to employer pensions exceeded $184 billion (Office of Management and Budget 2004, table 18-4). Despite the magnitude of these revenue losses and the sizable role of tax-deferred saving in providing retirement income, the distributional effects of these programs have received little attention.1 This paper helps fill that gap. We describe the development of a retirement saving module in the Tax Policy Center microsimulation model and present estimates of the current distribution of benefits from defined contribution plans and individual retirement arrangements.2

The distribution of pension benefits is not only an issue of fairness. First, evidence suggests that high-income, high-wealth households are more likely to finance contributions to tax-preferred accounts by shifting assets from other sources, rather than reducing their current consumption, whereas moderate-income households are more likely to finance contributions by reducing consumption.3 Thus, retirement saving incentives targeted at high-income households may be relatively ineffective ways to raise private and national saving. Second, evidence suggests that high-income and high-wealth households are more likely to be accumulating adequate private wealth to maintain their preretirement living standards in retirement, and that low- and middle-income households are more likely to face problems accumulating adequate amounts for retirement. Thus, retirement saving programs targeted at households with high income and high wealth will not encourage saving where it is most needed.4

Measuring the benefits that workers receive from tax preferences for saving is not a simple task, however. For an Individual Retirement Account (IRA), for example, the benefit depends on marginal tax rates at the time of contribution, the time of withdrawal, and during the accumulation period; the length of time the contribution is held in the account; the nominal and real rate of return; and the timing and form of withdrawals. For employer-sponsored plans, the effects are substantially more complex. The benefit depends on the nature of any wage offsets to employer pension contributions. It also depends on the economic incidence of nondiscrimination rules (since that incidence indicates how one party's contribution affects the applicable or allowable contributions for other parties).5

We find that about 70 percent of tax benefits from new contributions to defined contribution (DC) plans accrue to the highest-income 20 percent of tax filing units in 2004, and more than half go to the top 10 percent. Because eligibility for IRAs was subject to income limits, the tax benefits associated with IRAs are somewhat less skewed by income than contributions to DC plans. Still, almost 60 percent of IRA tax benefits accrue to the top 20 percent of households and more than 85 percent of benefits go to households in the top 40 percent.

By income level, the largest benefits as a share of after-tax income accrue to households with income between $100,000 and $200,000. Sizable benefits also accrue to households with income between $75,000 and $500,000. Thus, pensions provide the largest benefits, relative to income, for households roughly in the 80th to 99th percentiles of the income distribution. The benefits provided to the very wealthiest households are a significantly smaller share of their income, but are larger in dollar terms, than the benefits provided to the 80th to 99th percentiles.

The next section summarizes the major tax incentives for saving addressed in this paper. The second section describes the Tax Policy Center Microsimulation Model. The third section and the appendix summarize the steps taken to model retirement saving programs. The fourth section provides the central results. The final section concludes.

Notes from this section

1 For exceptions to this general rule, see Congressional Budget Office (2003b), Even and MacPherson (2003), Gustman and Steinmeier (1998), and Joulfaian and Richardson (2001).

2 We note that the tax treatment of pensions is a subsidy relative to an income tax, not a consumption tax.

3 Early research on 401(k)s found that the saving plans raised saving at all levels of income (Poterba, Venti, and Wise 1995). Subsequent research, which has addressed a number of econometric issues in earlier work, tends to find that 401(k) plans have not raised the wealth of relatively high-income households, but may have raised wealth of low-income households (Benjamin 2001; Engen and Gale 2000; Chernozhukov and Hansen forthcoming).

4 Congressional Budget Office (2003a) and Engen, Gale, Uccello (1999) review the literature on the adequacy of saving. For an important recent contribution, reaching a much more optimistic view than much of the previous literature on the adequacy of saving, see Scholz, Seshadri, and Khitatrakun (2003).

5 In a utility-based model, the benefits of tax-deferred saving contributions would also depend on the extent to which the contribution represents a net addition to private saving and whether there is an option value associated with pension coverage even for those who do not actually participate. These issues, as well as the issues related to nondiscrimination rules, do not arise in standard distributional analysis, but are interesting avenues for future research.


Note: This report is available in its entirety in the Portable Document Format (PDF).