Incentives for Retirement Savings
by Tom Yamachika, President, Tax Foundation Hawaii
During the past few months, the Tax Review Commission, a group provided for in our state constitution that is supposed to meet once every five years, has been busy at work. The Commission is tasked with recommending changes to our tax laws, and its consultant has recommended limiting the pension exemption that we now have in our state income tax code so that it only exempts $25,000 per year.
Our current pension exemption only allows taxpayers to exclude pensions as the result of an employer contribution. So, it applies if an employer puts something away for its employees, but it doesn’t apply if the employees put something away for themselves under a plan sponsored by the employer. For example, if I contribute $100 to my employer-sponsored 401(k) plan and my employer makes a matching contribution of $50, then when I retire and the plan pays me $180, only the one-third attributable to the employer contribution ($50 / $150 total) would be exempt from our state income tax.
Apparently, this rule was designed to take care of defined benefit plans, which many companies had in the old days and which our state government still has now. In modern times, however, people normally get, and employers normally offer, IRAs, Roth plans, 401(k) plans, and defined contribution pension plans. The distinction between the plans that are now taxable and those that are exempt is sketchy at best. If we as a policy matter want to encourage retirement savings, shouldn’t we be encouraging it whether the employer puts something away for the employee or the employees put something away for themselves?
The federal income tax system also has an incentive for retirement savings in that it allows a deduction for contribution to some retirement accounts such as traditional IRAs, even if the contribution is made after the end of the tax year. (Hawaii mirrors this incentive, but generally taxes distributions from the accounts, like federal law.) President Trump’s proposal for tax reform has not yet put this incentive on the chopping block.
This feature of our income tax system is particularly important because not all employers offer pension plans of any kind, and anyone can establish an IRA. One interesting story from one of our loyal readers illustrates this feature of our income tax system.
In February of one year, with the April 15 deadline fast approaching, father and son were at the kitchen table, with receipts, calculators, and tax forms strewn about the area normally occupied by plates, serving trays, and utensils.
“Argh,” says Son. “It looks like I’m going to owe money to the IRS. A little over $1,500.”
“And,” says Father, “you will need to deal with penalties for not paying enough in estimated tax.”
“Oh, no! I didn’t think of that one!”
“And did you put aside money for your later years?
“No…I’m having a hard enough time with the bills I have today!”
“You know what? I have an idea.”
“What is it, Dad?”
“I am going to give you $4,000. We’re going to open a traditional IRA for you and we will put the money in there. Put $4,000 on the IRA deduction line and see what happens.”
“I don’t owe any more! If you do that, Dad, it would be really great!”
“But there is one condition.”
“Oh? What’s that?”
“You’re going to put the tax refunds you get into the IRA so you can take the same deduction next year. And the same goes for the year following. And so on.”
“I can do that. Deal!”
That was a happy ending for Son, who escaped immediate financial troubles and was able to see a ripple effect from the savings; and for Dad, who encouraged his son to save money responsibly and was able to start teaching him how to invest it.
These times of decreasing employer-provided retirement benefits and the uncertainties of Social Security point up the need for government to retain incentives for people to provide for their own financial security after retirement.