It's Time to Raise IRA Contribution Limits

Expanding access to workplace retirement savings plans may soon be an idea whose time has come. On both the political Left and the Right, policymakers have proposed legislation that would extend coverage to at least some of the approximately 50% of private-sector workers who lack a workplace retirement plan. As legislators contemplate making these changes--many of which are reasonable and constructive--they should also give thought to fixing one of the largest inequities in the retirement system: indefensible differences in contribution limits for various types of retirement accounts.

One may argue about the precise size of America's retirement savings gap--the Employee Benefits Research Institute says it is $4.1 trillion, and Boston College's Center for Retirement Research puts the number at $7.7 trillion--but it is clearly pretty big. Moreover, an increasing number of members of both major political parties agree that legislative action is required to address the shortfall between what individuals have saved and what they will need in retirement.

What's on the Table One potential solution comes from Senator Orrin Hatch, R-UT, the chair of the Senate Finance Committee, who supports making it easier for small employers to offer 401(k)s. (401(k)s are far more common at larger employers than among smaller firms.) Hatch would allow small and midsized employers to establish "Starter 401(k)s," which would permit workers to contribute up to $8,000 pretax to a retirement plan each year. As companies grow, under Hatch's plan they would then gradate from the Starter 401(k)s, which have few administrative burdens, to traditional 401(k)s.

Earlier this year, Senators Susan Collins, R-ME, and Bill Nelson, D-FL, introduced legislation that would make it easier for smaller employers to form multiple-employer plans. MEPs essentially allow smaller employers to band together to achieve compliance efficiencies and economies of scale in 401(k) provision. Right now, the Department of Labor does not allow unrelated businesses to form MEPs; the Collins/Nelson bill would remove the requirement that businesses that are part of a MEP have a "common interest." Hatch also supports making it easier to form MEPs.

If adopted, the Collins-Nelson bill would appear to address some of the concerns that prevent some smaller employers from offering workplace plans. In a Transamerica survey of employers who do not sponsor a 401(k), about one third of respondents said that they would be "very" or "somewhat" likely to "consider joining a multiemployer plan offered by a vendor who handles many of the fiduciary and administrative duties at a reasonable cost."

While the aforementioned plans should at least incrementally expand the availability of workplace retirement plans, one legislator would go much further. Rep. Joseph Crowley, D-NY, the vice chair of the House Democratic Caucus, recently proposed mandating that all employers auto-enroll their employees in a retirement account and requiring employers to make a retirement account contribution, regardless of whether the employee does so. In the current Congress, that latter provision--which bears some similarity to the United Kingdom's pension system--is dead on arrival, but the auto-enrollment provision might have more appeal at either the federal or state level. As we have previously noted, Illinois recently enacted legislation that will ultimately require employers without workplace retirement plans to auto-enroll their employees in Roth IRAs.

Although the expansions of workplace retirement plans are generally welcome--workers participate in retirement savings program at much higher rates when they can easily save at work--these proposals maintain inequities in retirement plan contribution limits.

Right now, for example, workers generally may make pretax contributions of up to $18,000 in a traditional 401(k) plan, a total potentially rising to over $50,000 when employer matches are included. However, those who lack a workplace plan and instead contribute to an IRA may typically contribute only $5,500 each year. (For those 50 or over, higher "catch-up" contribution limits are available for both types of accounts, though the limits are still much higher for 401(k)s.) The Collins/Nelson and Crowley proposals would maintain these imbalances.

Hatch's proposal would not remove these inequities, either, as he envisions an $8,000 yearly contribution limit to Starter 401(k)s. If Hatch's proposal were adopted, individuals under age 50 saving for retirement might face contribution limits of $5,500 (if their employer offers no retirement plan and an IRA were their only option), $8,000 (if their employer offers a Starter 401(k)), or $18,000 (if their employer offers a traditional 401(k)).

To some extent, then, a person's standard of living in retirement might well depend on a decision beyond his or her control: which type of retirement plan, if any, an employer provides.

Unifying Contribution Limits One straightforward solution would be to adopt a uniform annual maximum contribution to tax-advantaged retirement plans. From the perspective of the government, it is more important that people save an adequate amount for retirement, rather than that they save in a particular type of tax-favored vehicle. That is how the system works in Australia, for example: Employees may save for retirement in their company-sponsored plan or in a self-managed superannuation fund, which is roughly equivalent to an IRA. Whether an Australian saves in one type of account or the other--or a combination of the two--the contribution limit is the same.

The United States has already moved partially toward a vehicle-agnostic retirement system. Because of rollovers from defined-contribution plans, there is already more money in IRAs than in 401(k)s and similar vehicles. Moreover, a recent Department of Labor proposal--which would apply a fiduciary standard to those providing advice on both IRAs and 401(k)s--reflects that in terms of achieving a decent retirement, both IRAs and 401(k)s are important.

As Morningstar's director of personal finance, Christine Benz, put it, "Unifying contribution limits is a straightforward initiative that simplifies retirement planning" and ensures equity between retirement investors who are saving in different types of accounts. As Washington lawmakers continue to debate options to enhance access to workplace retirement plans, it is important that they also revisit inequitable contribution limits, which also detract from retirement security in America.

Scott Cooley is Morningstar's director of policy research and formerly served in a variety of analyst and management roles at the firm. He is also a graduate student at the University of Chicago, focusing on political science. Unless specifically indicated otherwise, the views that he expresses in this column are his own.