401(k) Plans May Be a Better Deal for Low Wage Workers Than We Thought

By :: January 10th, 2012

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.


  1. Ginter Vurlicer  ::  8:42 pm on January 10th, 2012:

    The comments below may not apply to Romney’s Tax Plan, but they certainly apply to Retirement Plans — 401Ks, IRAs, Savings and Investment plans, bank accounts, etc.

    Needed Financial Reform

    A huge financial reform that is needed is treating withdrawals from long term investments as income, when, in fact, the amount withdrawn has the same or less purchasing power than the original investment.

    You put in three grand in 1970 and withdraw 20 grand in 2011. You get taxed, as a profit, the 17 grand that has grown by compound interest of reinvested interest payments. However the amount invested and the amount withdrawn both have the same purchasing power in their respective years. There is no profit. There should be no income tax liability. It is absolutely no different than putting a grand in the bank and withdrawing it some time later. There is no change in value over a short period of time, so the withdrawal is not reported as income. The three grand investment could have bought a nice family sedan in 1970, the twenty grand could buy an equivalent sedan in 2010. You have merely defrayed the purchase of an automobile for forty years.

    While your money was earning interest to keep up with inflation, the money was loaned out many times to businesses, builders, and buyers. The short term incomes and profits generated by the loans were taxed every year for forty years. Now the IRS wants an additional “pound of flesh” declaring that your seventeen grand appreciation is pure profit. It is not profit. It is not income. You are merely withdrawing financial value that has kept up with inflation over forty years. It is no different than a simple bank withdrawal. Every long term savings account should be exempt from taxation whenever the gains in the account track the inflation index between the year invested and the year withdrawn.

    The IRS assumes that all dollars are equal in value and just pays attention to changes in numbers, but, without indexing dollars to particular years and the consumer price index for that year, dollars in different years can be as different as Euros and Yens. However, it is in the interests of collecting more money than it deserves that the IRS and the Congress ignore these realities when it comes to long term investments.

    At present, the IRS is stealing billions of dollars from seniors who make withdrawals from their long term savings and investment plans. All advocacy and protection organizations need to get the Congress to promote savings by Americans by exempting withdrawals from long term savings and investments when there has been no change in the net purchasing power between the initial investment(s) and the withdrawal. The IRS simply needs to allow (and teach taxpayers) the use of the Consumer Price Index to discount current dollars and inflate dollars for investments before 1980, when the index was set to 100.

    This is fair. It makes financial and economic sense. And it levels the negative effects of inflation, which may be increased by government policies.

  2. Jack B  ::  7:56 am on January 11th, 2012:

    Ginter Vurlicer…
    Aren’t all these issues addressed by the Roth IRA?

  3. Michael Bindner  ::  8:39 am on January 11th, 2012:

    This makes sense, especially since low wage workers often work in more monopsonistic labor markets – meaning they don’t negotiate their wage, they take it or leave it. This is also why minimum wage increases don’t cost jobs. The problem with the 401(k) is potentially what it holds. If it holds employer voting stock, giving workers more of a say, that can be a good thing. If it holds unaccountable shares managed by big finance, it only supports the free hand of CEOs to offshore jobs, which is not in the long term interest of American workers, although lower wage workers are less vulnerable than manufacturing workers to this.

  4. Michael Bindner  ::  8:44 am on January 11th, 2012:

    More fair would be shifting away from indivdiual taxation to consumption taxes, with people who contributed to tax free retirement accounts getting a rebate to offset at least the VAT portion, although in truth if the VAT or a VAT-like net business receipt tax replaces income tax collection it simply offsets employment taxes embedded in the wage.

  5. Michael Bindner  ::  8:51 am on January 11th, 2012:

    Low income workers with 401(k)s likely won’t have much income tax liability, so the tax treatment of their accounts is not important, since they are unlikely to collect enough to pay any tax anyway.

    High income workers need to realize that any rate cut, exclusion or discounting simply shifts the baloon of taxation to higher rates or to imposing a tax liability on their own children, rather than the next generation as a whole – since debt is ultimately a future tax, unless it is monetized. If it is monetized, then the resultant inflation makes the assets of the wealthy worth less and has far more of an impact on them (since workers simply demand higher wages) than it does on labor. It is better to raise taxes on the wealthy now, preferably in a way that does not cause distortion or decreases consumption than to put it off. Consumption taxes should fund current domestic spending (entitlement, domestic defense, non-defense discretionary), with a surtax on the wealthy funding net interest, foreign spending and debt repayment. Decreasing the amount available for speculation is also a good thing, since it limits the funding of junk investments in speculative IPOs and mortgage bond schemes.

  6. Ralph H  ::  11:18 am on January 11th, 2012:

    However, lower income workers will comparatively benefit more at retirement for an employer contribution left to compound, since their other savings and SSI will be less.

    As a side issue as a small employer who sponsers a 401k, in retrospect I would not offrer one again. Why — the annual fees for administration are excessive and cut int6o the overall employee benefit. The US contributes mightly in their regulations which mandate a total rewrite every 3 years to account for. BS like the stimulus law. Main beneficiaries are administrators, financial providers and lawyers. Any fees that cut benefits are not beneficial.

  7. AMTbuff  ::  12:38 pm on January 11th, 2012:

    My guess is that this effect is a result of the 401k rules which require inclusion of low-income employees when high-income employees are covered. The latter value the 401k, are willing to accept lower pay to get it, and demand that the employer offer it. The former get a relatively free ride, since they are not willing to accept reduced pay.

    The non-discrimination rules for 401k’s may be the first instance of a desirable unintended consequence that I’ve ever seen.

  8. Vivian Darkbloom  ::  1:22 pm on January 11th, 2012:

    Maybe, but I would elaborate:

    1. I suspect that higher income employees tend to negotiate their wage and benefit packages more than lower income employees do. The effect on higher income employees is as you state. However, since lower income employees likely have more standard pay packages there is no explicit negotiation trade-off going on; and

    2. Higher income employees very likely have higher 401(k) participation rates (here, your reference to “require inclusion” could be misleading—the fact that employees must be eligible to participate does not mean they do). The lower pay trade-off with respect to lower standardized pay packages may not be as important to employers because a smaller percentage of those employees use 401(k).. Employers may not be inclined to reduce wages across the board at the lower end simply because, say, 40 percent of those employees participate in (or fully utilize) the 401(k) possibility.

    How this study was done would, of course, be very important to the validity of any findings. Did the study, for example, compare firms that offer 401(k) plans to companies that do not offer them? Or was the exercise to compare wages among employees who participate or who do not participate within the *same* firm. The effect, if any, of #2 above would be particularly noticeable, I think, if the study concentrated on differences in pay within the same firm. Methodology is extremely important.

    And then there is the age/generational factor. A 401(k) contribution made at an early age provides tax benefits (in the form of deferred savings) for many more years than a comparable contribution made at, say age 64. Since one generally earns higher wages at the end of one’s career than at the beginning, the tax rules also, in a sense, on average, favor lower income earners. The tax benefit is not only the immediate tax savings but a product of those savings over the deferral period. In other words, the 401(k) is an even better deal to the extent low wages are combined with tender ages.

  9. Secondary Sources: 401(k)s for Low Wage Workers, Financial Transaction Tax, Liquidity Trap – Real Time Economics – WSJ  ::  2:02 pm on January 11th, 2012:

    […] […]

  10. Ginter Vurlicer  ::  3:18 pm on January 11th, 2012:

    To add insult to injury (re: inflated savings and devalued dollars), the IRS demands that seniors over 70 withdraw a portion of their savings every year so they can be taxed — rather than passed on to their heirs as tax-free gifts or inheritance proceeds. So the rapacious monster that is the IRS gets you coming and going.

    With the recent crash and stagnation of long term savings accounts, there are few seniors that can claim that their Savings and Investment Plans have earned more than the lost value from the cumulative effects of inflation over the forty plus years that they have been making steady payments from their paychecks. Thus any forced withdrawal represents a net loss in the real value of their contributions. Seniors should be able to claim a loss (gambling loss?) on these withdrawals that can be used to off-set their other taxable incomes.

    (Of course, it is absurd that seniors are required to pay a tax on their Social Security payments — money that they and their employers gave to the government for safe keeping and insurance against catastrophic losses. Any disbursements from the government should be tax free.)

  11. Ginter Vurlicer  ::  3:42 pm on January 11th, 2012:

    RE: Roth IRAs

    Yes they are great for paying your tax up front and letting those funds grow on a tax-free basis upon withdrawal. But they are a recent option for savers and there is a limit on your yearly contributions. They do not cover the case of seniors who made contributions with after-tax dollars to their Savings and Investment Plans and now have appreciated funds that are worth less than the funds that were contributed (once the Consumer Price Index is used to adjust all the dollars).

    The IRS simply wants to take the net change in the raw numbers (dollars out minus dollars in) as “pure” profit, when, in fact, adjusted dollars out minus adjusted dollars in equals a net loss in value — no profit, no gain, no tax, and a claim against other incomes. Are you wondering why there is so much silence on this issue? Why the IRS wants to squelch any discussion about CPI adjusted dollars?

    The same problem comes up with any other value held for a long time that was bought with expensive dollars and is sold with cheap dollars. Any tax liability should be determined using adjusted dollars. But the IRS doesn’t want to hear about it.

  12. Ginter Vurlicer  ::  1:46 am on January 12th, 2012:

    Roth IRAs are good for avoiding future inflated dollar figures that get taxed at the senior’s tax rate, however how are you going to claim a loss of values (real purchasing power) to the IRS when the Roths have accumulated less compound interest than the cumulative effects of inflation? Unless the IRS allows you to discount dollars, you look (from the raw numbers) like you made a handsome “profit” on your original investments.

    The same applies to every savings account. Banks will never pay you more than the prevailing inflation rate, so every year you have lost objective value from your account. You should be able to claim the loss in values to offset the earnings to your account in the form of interest and other real incomes.

    Again, the IRS doesn’t want to hear about it…

  13. Ginter Vurlicer  ::  1:47 am on January 14th, 2012:

    Aren’t all these issues addressed by the Roth IRA?

    Well, no:

    How does a worker now a decade from retirement age take advantage of Roth IRAs when his previous SIP was a mix of pre-tax and after-tax contributions?

    Does his plan have strict accounting of which shares are which? If he converts his after-tax funds to Roth IRAs, does he have to pay the appreciated value (pure numbers, not discounted by the “time dis-value of money”) as capital gains before the funds can grow tax-free?

    What if the discounted value of all the after-tax fund growth is still lower in value than the funds contributed — is a tax still due when converting to a Roth? What forms can be used to claim negative capital gains.

    Can the worker get an interest rate from a relatively small IRA comparable to one in a multi-million dollar investment plan managed with leverage by highly paid managers?

    All of these issues can be addressed with the stroke of the President’s pen by forcing the IRS to accept discounting of all savings earning dollars by the Consumer Price Index. That promotes savings by protecting the funds from being unfairly taxed by phony “growth” at less than the inflation rate. As the savings stimulate growth in the economy, the IRS will get their funding by more economic activity — the “trickle up” effect / theory of economics, widely practiced in healthy economies.

  14. Ginter Vurlicer  ::  6:36 am on January 15th, 2012:

    Until the IRS gets its head out of the sand and acknowledges the fact of inflation, practically all savings and investment plans are a rip-off / losing proposition for the average person. Forty years from now prices will be eight to ten times what they are now. Few funds will keep up their objective value relative to inflation but the appreciated dollar figures minus the 10 to 13 percent basis will get taxed at the senior’s rate once he or she (and every one else) becomes a “millionaire” by the decreasing value of the dollar.

  15. Ginter Vurlicer  ::  5:28 am on January 24th, 2012:

    If you do all the right things with respect to being frugal and investing wisely and end up with a nice nest egg that you can make withdrawals from during your retirement years, the IRS is going to take 10 to 20 percent of the withdrawals, even if your savings and investments were made with after-tax dollars.

    After many years of inflation, the growth in your savings and investments looks to the IRS like pure profit and taxable income, even if, in fact, your funds have suffered a net loss in value because of the decreased purchasing power of current dollars relative to the dollars you invested over your working years.

    You paid payroll taxes, you managed to save some your after-tax dollars into an investment plan, your savings grew by compound interest, but inflation and the stock market bust and stagnation caused you to fall behind in real purchasing power. Now, as a senior, the IRS forces you to make withdrawals (after age 70) and then taxes your withdrawals as profit income. You are being double taxed at the front end and at the back end.

    The only fair way to determine taxes on all long term savings is not with some simplistic capital gains calculation of current dollars out minus original dollars in, but by adjusting your original basis up to current dollars using the government’s Bureau of Labor Statistics’ Consumer Price Index (CPI). For most people the result will be a “capital gains” loss and therefore no tax liability on the withdrawal (once the IRS is forced by legistlation or court judgements to accept such calculations). Any loss in real values, expressed in current dollars, should be usable to off-set other incomes.

    If adjusting your basis dollars still shows a net gain in real value, congratulate yourself and pay the tax on the net real capital gains / profits. The adjusted gains will be certainly much smaller than the appreciated “profit” on an unadjusted basis.

    For example, you withdraw $20,000 from your savings and investment plan in 2010. Your financial institution reports that the basis for this withdrawal is $3,000 with after-tax funds that you invested around 1970. The IRS now says that your gain is $17,000 and your, 15%, tax liability is $2,550. However, the CPI in 1970 was around 38 (with 1980 dollars set at 100). The CPI for 2010 is around 218. Adjusting your original basis dollars up to 2010 dollars (3000 x 218/38) puts your basis at $17,210. Your real profit is only $2,790. Your tax, at 15%, is $418. So without making an adjustement to your basis using the government’s own numbers, the IRS is taking an extra $2,132 out of your pocket, that it does not deserve. Remember your payroll tax on the original $3000 was probably close to $600. Adjusting that tax up to current dollars, means that you have already paid $3,442 in taxes. It is morally, ethically, and economically indefensible that the IRS wants you to pay $2,550 now (again!).

    This sort of thing happens every year to every senior who makes a withdrawal from his or her retirement fund. Multiply the above example by the number of such seniors and you are talking about real money that the IRS is stealing (by double taxation) from American citizens who can ill afort to be overtaxed on top of their medical expenses and steadily rising prices for everything.

    You can do a lot of fancy money management and planning for your retirement, but until this double taxation is corrected by forcing the IRS to accept adjusting dollars for different years to determine real tax liabilities, as a senior you will be seeing a good portion of your hard won earnings evaporate.

    In the example above, it seems like you have been doing really well in building up your nest egg, but inflation (especially in the mid 70s to mid 90s), per the CPI indices, chewed up a good bit of the value of your earnings. After forty years you only gained 16% real value on your original basis dollars. That is equivalent to about four tenths of a percent compound interest earnings rate (after subtracting out inflation). It is absurd that the IRS, refusing to acknowledge the realities of inflation, wants to essentially wipe out all of your real earnings with a fifteen percent surcharge on your total “interest income” of $17,000, but try to plead your case with them.

    Of course, all the auditors, financial specialists, managers, and directors at the IRS fully understand how inflation helps them collect more “capital gains” money than they deserve, but economic fairness is not their primary mission — they want to collect every dollar that the ridiculously complex tax laws allow them to collect.

    As long as workers fail to understand how inflation kills the greatest portion of their investment earnings and how the IRS kills whatever is left, all of the most careful financial planning will end you up where you started from.

  16. Ginter Vurlicer  ::  7:09 am on January 24th, 2012:

    The IRS (and congress) is afraid of Roth IRAs and so there is a limit on what can be invested in Roths each year. We need to thank Senator Roth for sponsoring the legislation that set them up. Obviously he understood the effects of inflation and the huge unfair bonus that the IRS receives on capital gains from investments over long times in the presence of inflation.

    Elsewhere on the Tax Policy Center there is a discussion on the long term effects if the government allowed unlimited conversions from conventional IRAs to Roths. There is a benefit short term but a larger revenue penalty in the future (even adjusting for inflation!).

    My point is that the IRS, General Accounting Office, Congress, Tax Policy Center, think tanks, tax policy advisers, etc. all understand the impact on the IRS of making adjustments to earnings based on real inflation numbers.

    In the current climate of legislation needing to be revenue neutral, in order for the IRS to accept adjustments for inflation, using the CPI or other published statistics, someone other than senior citizens making withdrawals from their savings and investment plans will need to pay more taxes. So, just keep sticking it to the seniors and keep on protecting the guys (and companies) who can afford to pay big bucks to congressional campaigns.

  17. BPP401k.com Newsletter 01.18.12 | | Benefit Plans Plus 401kBenefit Plans Plus 401k  ::  4:39 pm on May 13th, 2012:

    […] 401k Plans May Be a Better Deal for Low Wage Workers Than We Thought Total pre-tax compensation for low-wage workers who participate in 401ks increases while it remains about the same for those making more money, who get all their benefits from tax-savings. Source: Tax Policy Center […]

  18. Norm  ::  4:58 pm on August 19th, 2014:

    Thinking like that is really imrsespive

  19. health insurance  ::  8:35 am on February 16th, 2015:

    Your answer was just what I needed. It’s made my day!