The New Retirement Savings Tax

In 1991, the New York Times reported on the remarkable life of Theodore Johnson. Theodore did not win the Nobel prize, nor was he a celebrity, inventor, or even a local celebrity of any real fame or renown. Rather, Theodore was a UPS driver. This was in a time before the internet hit any critical mass or made any great sensational news, so Theodore was not a UPS driver who went viral for a video or some sort of social media moment. No, Theodore was written about in the New York Times for donating $36 million dollars of his $70 million dollar fortune to establishing a scholarship fund. Now, your first thought might be that Theodore inherited that money, but far from it. Theodore never made more than $14,000 a year working as a UPS driver, and he retired in 1952 after saving $700,000 during his career with UPS in company stock, which since ballooned one-hundred-fold into $70 million dollars over the following thirty-nine years. It’s worth asking: How did Theodore manage to do it? His simple answer: “When I was a young man, a friend who worked as a broker told me to save 20% of every paycheck and to buy stock with it, rain or shine. I asked him how I’d make ends meet at first, and he said, ‘Look, if the government gave you a 20% greater income tax today, you’d just grumble, pay it, and figure it out.’ So that’s exactly what I did.”

The New Retirement Savings Tax

So here’s the bad news: You, too, now have a retirement savings tax. It is between $22,500 and $40,000 per year per adult in your household. It’s not optional, so now’s the question, how do you make do? For some people, this is an unreasonable and impossible question to answer. They earn and live on less than this every year, so this question is a non-starter. But for you, the people earning $40,000 and more a year, how do you make do with this? If your personal tax here is $22,500 and you earn $40,000 a year, how do you handle a 56.25% retirement savings tax?! Well, simply put, you make do as the people who only earn $17,500 a year and save nothing do. Sounds crazy, yet about one in five adult Americans live on this amount of money or less. Of course, if your income is sixty, ninety, a hundred and twenty, or two hundred thousand a year, the ratio of that bottom tax goes down, but it may make sense for you to bump up to paying a higher flat tax. So let’s talk about what that tax is:

Here’s the really good news: Unlike many taxes we pay, you get to keep your retirement savings tax. If you get the tax deduction today by doing pre-tax savings, you’ll pay taxes later, but you always owed those taxes. If you get your tax advantage later by doing a Roth IRA and 401(k) contributions, congrats, you’ll get to keep 100% of the outcome.

Now, the reality is that you already pay a guaranteed retirement tax: OASDI tax or “social security” tax, which costs you 6.2% of your income up to an annual limit or 12.4% if you’re self-employed ($160,200 as the income limit in 2023). You have paid this tax your entire life (unless you were working before the great depression, which seems unlikely at this point) and will continue to pay it so long as you earn an income. Yet, social security’s retirement income replacement ratio can be as low as 25% for those who pay up to the tax’s income limit but don’t earn more than that amount. Why is that?

Inertia Bias

On earth, there are two countries. One has an organ donor rate of 99.98%, the other has an organ donor rate of 12%. You might assume that these countries are wildly different: “Well, one must be a cruel authoritarian regime, forcing everyone to be an organ donor for the good of the public, and the other must be a libertarian paradise in which it’s every man for themselves!” The reality is far from it. The two countries are Austria and Germany, culturally almost identical and, at certain points in history, the same country. So what’s the deal if they’re so similar? It’s shockingly simple: Austria uses an “opt-out” system, and Germany uses an “opt-in” system. The result is that only 0.02% of people in Austria go out of their way to not be organ donors, while 12% of Germans go out of their to be organ donors. The same psychological mechanism is prevalent in our retirement system. You pay into social security because it’s automatic. You never signed a form, consented to it, or otherwise had any say in what the tax rate was unless you were in congress back in 1939. The same principle helps retirement savers in the United States. Retirement plans that auto-enroll employees typically see participation rates greater than 90%, while retirement plans with voluntary enrollment typically see enrollment rates closer to 50%. The simple difference between whether five in ten or nine in ten employees are getting the free money of retirement plan matching and saving for their futures is simply whether they had to sign up! The same effect occurs in savings rates. Employers have the option of setting their employee’s default retirement savings rates at anywhere from 1% to 10% of their wages, and the same trend is prevalent here. Those employers who sign their employees up automatically at 10% tend to see retirement savings rates average greater than 9%. Those who sign their employees up at 3% tend to see average savings rates no greater than 4%. Once again, the power of “default” strikes again!

Overcoming Inertia

The only thing that can help you overcome inertia is taking control of your personal finances right now. This is the commandment if you are still working: Log into your company retirement plan and turn that dial to eleven. Max out your retirement contributions if you can afford them. Already doing it? Open a Roth IRA and max it out; if your income is over the limit, that’s fine. Make a non-deductible IRA contribution and then do a Roth IRA conversion. Whatever you do, carpe diem! Seize the day, take action, and overcome inertia to improve your financial future!