Key Findings
- Traditional and Roth-style taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities.
-neutral savings accounts are key components of the US federal income tax. They encourage saving for retirement and other defined financial goals while also removing the tax penalty on saving, boosting income growth and economic growth. - Defined contribution plans, like 401(k)s, are usually employer-sponsored and are the most popular way for households to save for retirement, followed by individual retirement accounts (IRAs) that savers set up independently. A variety of other accounts, such as health savings accounts (HSAs) or 529 plans, are used as saving vehicles on a less frequent basis for specific types of expenses, such as healthcare or education.
- In 2018, taxpayers contributed $332.5 billion to defined contribution accounts and $70 billion to IRAs. Taxpayers aged 35 to 55 make up nearly half of all 401(k) contributions, suggesting retirement saving peaks with mid- and later-career workers. Traditional and Roth IRA withdrawals generally increase with age. However, about 15 percent of withdrawals occur before the age of 60, often to address financial needs.
- Tax-neutral retirement contributions are made broadly across the income spectrum and across ages, but older and higher-income households tend to benefit the most. The underlying complexity of the retirement system disproportionately impacts younger and lower-income savers who may not have the time or resources to navigate it.
- Universal savings accounts (USAs), tax-neutral savings vehicles with unrestricted use of funds and relatively few limitations, would dramatically simplify households’ ability to save and plan for their financial future. The US could follow the lead of Canada and the United Kingdom by setting up a supplementary USA to move the system in the right direction.
Review of the Current US Tax Treatment of Saving
Under the US federal income tax, income is typically subject to tax when it is earned, and any growth from saved income is taxed again once it is realized. To encourage greater saving, the US federal income tax provides tax-neutral treatment to some types of saving through a variety of accounts. The type of tax treatment, contribution limits, withdrawal rules, and use cases for contributions all vary by account, leading to a complicated system for households to navigate.
Tax-deferred accounts, also known as traditional accounts, provide an income tax deductionA tax deduction is a provision that reduces taxable income. A standard deduction is a single deduction at a fixed amount. Itemized deductions are popular among higher-income taxpayers who often have significant deductible expenses, such as state and local taxes paid, mortgage interest, and charitable contributions.
for contributions and defer taxes owed on the growth until the taxpayer makes a withdrawal. Roth account contributions are subject to income tax up front, but the principal amount and any investment growth are both tax-free upon withdrawal. Traditional and Roth treatments are ultimately equivalent under fixed taxed rates.
Both traditional and Roth accounts ensure that saved income is taxed only once and treated the same as income that is consumed.[1] This encourages greater saving, helping households plan for future expenses and raise their after-tax incomes. Saving also fuels investment, both here and abroad, contributing to economic growth.
The two main tax-neutral retirement accounts are defined contribution (DC) plans and individual retirement accounts (IRAs). DC plans are employer-sponsored, and permit contributions from both employers and employees. A typical example is a 401(k) plan for a private sector employee.
IRAs, on the other hand, are privately held accounts that individuals establish and contribute to. Both DCs and IRAs often accept rollovers, which are transfers of funds from one retirement account to another, while preserving the tax advantages for retirement savings. IRAs and employer-sponsored DC plans were established in the 1970s, and about 54 percent of non-retired adults participate in either type.[2]
Other tax-neutral savings accounts can be established for specific expenses, such as for healthcare and education. For example, health savings accounts (HSAs) allow for tax-deductible contributions from employees and employers, avoiding both income and payroll taxA payroll tax is a tax paid on the wages and salaries of employees to finance social insurance programs like Social Security, Medicare, and unemployment insurance. Payroll taxes are social insurance taxes that comprise 24.8 percent of combined federal, state, and local government revenue, the second largest source of that combined tax revenue.
, and tax-free investment earnings and withdrawals. Flexible spending account (FSA) contributions are also free of income and payroll tax, as are withdrawals for qualified medical and dependent care expenses. By providing both a deduction for contributions and tax-free withdrawal, these accounts go beyond neutral treatment and actively subsidize saving.
A common tax-neutral education savings account is a 529 plan, which includes post-tax contributions the year they are made but allows for tax-free investment earnings and withdrawals.
In all, the US tax code provides at least 11 types of tax-neutral savings accounts, each with its own specific contribution limits and rules related to withdrawals.[3] For example, contributions to IRAs are limited to $7,000 in 2024, but people aged 50 or older may contribute an additional $1,000 in catch-up contributions. Withdrawals from IRAs prior to age 59 ½ may be subject to a 10 percent penalty, except for withdrawals of principal contribution amounts from a Roth IRA.[4] The IRS provides an extensive list of penalties and exceptions for early withdrawal from retirement accounts.[5] Other accounts, such as FSAs, have a “use it or lose it” feature, where taxpayers forfeit their contributions if they do not use them for qualifying expenses in that year.[6]
As Table 1 illustrates, overlapping and differing accounts, tax benefits, contribution limits, use cases, and withdrawal rules add up to a complicated system that can confuse even savvy taxpayers.
Taxpayers Contributed a Total of $332.5 Billion to Defined Contributions Accounts in 2018
Despite the complexity of the tax-neutral retirement system, the data shows it remains a primary way households save and financially plan for retirement.
In 2018, taxpayers contributed $332.5 billion to defined contribution accounts such as a 401(k)s or 403(b)s. Taxpayers aged 45 to 55 years old made up 27 percent of total contributions at $91.2 billion, followed by taxpayers aged 35 to 45 years old at 22 percent and $73.3 billion in contributions.
Taxpayers aged 35 to 55 make up nearly half of all 401(k) contributions, suggesting retirement saving peaks with mid- and later-career workers. Contributions begin to decline for taxpayers aged 55 and older as retirements become more common, with only about 0.4 percent of contributions made by taxpayers older than 75.
Taxpayers Contributed $70 Billion to IRAs in 2018
Taxpayers contributed $70 billion to IRAs in 2018, about 21 percent of the amount contributed to defined contribution plans.
IRA contributions tended to skew slightly older than DC contributions. Individuals aged 60 to 65 made the largest share of contributions at 16 percent, or $10.9 billion. Individuals aged 55 to 60 were a close second, making 15 percent of total contributions at $10.8 billion.
IRA contributors may skew older than DC plan contributors for several reasons. Unlike DC plans, people must actively set up an IRA and make contributions, which could be more common among older households. Alternatively, people could prioritize contributions to DC accounts first, which means older households earning more on average are more likely to have extra savings to contribute to IRAs.
15 Percent of IRA Withdrawals in 2018 Were Taken by Working-Age Taxpayers
Traditional and Roth IRA withdrawals generally increase with age, as 85 percent of withdrawals in 2018 were taken by taxpayers aged 60 or older. However, about 15 percent of withdrawals occur before the age of 60. Working-age taxpayers withdraw a significant amount from retirement accounts for other uses, such as home down payments, supplemental income for job loss, or financial emergencies.
Withdrawals by working-age taxpayers may be subject to tax owed and a 10 percent penalty for early withdrawals depending upon the circumstances, reducing their savings and setting back their retirement plans.
Total IRA Balances Totaled over $9.1 Trillion in 2018
The total balances for individual retirement accounts mirror the pattern of contributions. The market value of IRA balances tends to increase with age until 65 to 70 years old, when they tend to decline as savings are withdrawn during retirement and required minimum distributions (RMDs) kick in. Households between the ages of 65 and 70 held the highest end-of-year fair market accounts at nearly $1.8 trillion. Prime working-age households between the ages of 30 and 55 held nearly $1.5 trillion in IRA balances.
Private sector research on 401(k) account balances shows a similar trend. For taxpayers in their 20s in 2018, the average balance ranged from $4,160 for 401(k) plans established in the last two years to $19,513 for plans over five years old. Taxpayers in their 50s with a 401(k) account had a balance worth $30,475 on average for new accounts, increasing to nearly $302,000 for long-standing accounts over 30 years old.[7]
59 Percent of Retirement Contributions Were Made by Taxpayers Earning between $50,000 and $200,000 in 2018
Retirement contribution amounts tend to increase with income. About $100 billion in DC contributions and $25 billion in IRA contributions in 2018 were made by taxpayers earning under $100,000. Taxpayers with incomes between $100,000 to $200,000 made up 36 percent of retirement contributions at $146.2 billion, followed by taxpayers earning $200,000 or more at $131.4 billion. Taxpayers earning between $50,000 and $200,000 contributed 58.9 percent of total retirement contributions in 2018.
Taxpayers earning under $50,000 contributed the least to DC and IRA plans in 2018, reflecting the fact that they have less to save than higher earners and may be less inclined to navigate the complexity of the existing system.[8]
DC plans like 401(k)s were the more popular contribution option, making up 73.8 percent of contributions from taxpayers earning under $50,000 and about 75.6 percent of contributions from taxpayers earning $1,000,000 or more.
Taxpayer participation in tax-neutral retirement accounts also rises with income. For taxpayers earning between $15,000 and $20,000, for example, 20.2 percent contributed to a 401(k) or similar plan, and 2.5 percent contributed to an IRA. Of taxpayers earning between $100,000 and $200,000, 77.3 percent contributed to a 401(K) or similar plan, and 21.4 percent of that group contributed to an IRA.
The table below also shows taxpayers across the income spectrum tend to participate in employer-sponsored plans like 401(k)s more often than IRAs, likely because they do not require additional legwork to establish and contributions come directly from payroll. In 2018, about 41.7 percent of taxpayers contributed to a 401(k) or similar plan, while 9.1 percent contributed to an IRA.
Options to Streamline the Tax Treatment of Saving
The existing tax treatment of saving in the US has successfully encouraged millions of taxpayers to use tax-neutral accounts as a critical part of their retirement plans. However, the system suffers from complicated and overlapping rules that can discourage certain taxpayers from participating and improving their financial well-being.
Many of the rules are well-intended, as policymakers target certain accounts to help taxpayers with specific challenges like medical expenses or a disability. Similarly, the early withdrawal penalty on retirement savings is intended to discourage the use of savings before retirement. However, these limitations increase complexity and confusion for taxpayers who are generally looking to build financial security by saving for an uncertain future.
The most promising way to simplify the system, boost saving, and ensure access to people across the income spectrum is through universal savings accounts (USAs), which are tax-neutral savings vehicles with unrestricted use of funds and relatively few limitations.[9]
Contributions made to a USA could be used for any type of expense, such as buying a home, funding education, paying for emergencies, or starting a business. The simplicity of USAs is a major improvement over the status quo, encouraging people who otherwise would not participate in a retirement plan or incur a penalty for early withdrawal to save for the future.
Ideally, the entire system of tax-neutral accounts would be overhauled in favor of USAs. However, this reform could entail major changes to federal revenue in addition to disruption for people anchored to the current system. Short of an overhaul, the US could follow the success of the United Kingdom and Canada, two countries that provide USAs up to a defined contribution limit as a supplement to their respective retirement systems.[10] Low- and middle-income earners in both countries have broadly participated in USAs, showing that the simplicity and flexibility of these accounts is attractive to households across income levels.[11]
A supplementary USA would move the American system in the right direction, and the revenue loss could be offset by other changes within the system, such as a repeal of health savings accounts.[12]
Conclusion
Internal Revenue Service data from 2018 shows that American taxpayers across incomes and ages are broadly bought into our system of tax-neutral plans like 401(k)s and IRAs to support their retirement goals.
However, the system in its totality suffers from complicated rules, limitations, and overlaps that make it an uphill battle for households that do not have the time or inclination to navigate it. Younger and lower-income households have a more difficult time saving outside this system, and the complexity of the existing tax-neutral options only adds to the challenge.
Universal savings accounts offer a major simplification of the existing system and could be tested in the US and modeled after success in the UK and Canada without disruption to the status quo. A supplemental USA could pave the way toward broader reform to ensure the tax system does not stand in the way of financial success.
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[1] Erica York, Garrett Watson, Alex Durante, and Huaqun Li, “How Taxing Consumption Would Improve Long-Term Opportunity and Well-Being for Families and Children,” Tax Foundation, Oct. 12, 2023, https://taxfoundation.org/research/all/federal/us-consumption-tax-vs-income-tax/.
[2] Federal Reserve, “Economic Well Being of U.S. Households in 2022,” May 2023, https://www.federalreserve.gov/publications/2023-economic-well-being-of-us-households-in-2022-executive-summary.htm.
[3] Congressional Research Service, “Tax-Neutral Savings Accounts: Overview and Policy Considerations,” Mar. 31, 2023, https://crsreports.congress.gov/product/pdf/R/R47492.
[4] Internal Revenue Service, “Topic no. 557, Additional tax on early distributions from traditional and Roth IRAs,” https://www.irs.gov/taxtopics/tc557.
[5] Internal Revenue Service, “Retirement topics: Exceptions to tax on early distributions,” https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-exceptions-to-tax-on-early-distributions.
[6] Internal Revenue Service, “Health Savings Accounts and Other Tax-Favored Health Plans,” https://www.irs.gov/pub/irs-pdf/p969.pdf.
[7] Sarah Holden, Steven Bass, and Craig Copeland, “401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2018,” Employee Benefit Research Institute, Mar. 4, 2021, https://www.ebri.org/docs/default-source/pbriefs/ebri_ib_526_401kxsec.4mar21.pdf?sfvrsn=80823a2f_6.
[8] Congressional Research Service, “Individual Retirement Account (IRA) Ownership: Data and Policy Issues,” Dec. 9, 2020, https://crsreports.congress.gov/product/pdf/R/R46635/3.
[9] William McBride, Huaqun Li, Garrett Watson, and Alex Durante, “Simplifying Saving and Improving Financial Security through Universal Savings Accounts,” Tax Foundation, May 29, 2024, https://taxfoundation.org/research/all/federal/universal-savings-accounts-financial-security/.
[10] William McBride, “Canada’s Tax-Free Savings Accounts Are a Huge Success. U.S. Lawmakers Should Take Note,” Tax Foundation, Feb. 8, 2024, https://taxfoundation.org/blog/tax-free-savings-accounts-tfsa-canada/; Garrett Watson, “America Should Learn from Successful Universal Savings Policy Across the Pond,” Tax Foundation, May 15, 2024, https://taxfoundation.org/blog/uk-individual-savings-accounts-isa/
[11] Ibid.
[12] McBride, Li, Watson, and Durante, “Simplifying Saving and Improving Financial Security through Universal Savings Accounts.”
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