Contribution Limits and Retirement Savings

Abstract

As tax-deferred saving is become increasingly popular, policy makers are keen on encouraging everyone in participating in tax-deferred saving plans. To pursue this goal, policy maker often increase contribution limits for tax-deferred savings. But whether this action is effective or not is not clear from empirical investigations. Moreover, the consequences of contribution limit increase for savers or investors are not well understood either. Contribution changes may affect the risk taking behavior of investors, and due to tax considerations it may affect asset location decision of investors as well. So in this paper, we present an augmented tax-deferred savings model to assess the impact of contribution limit in promoting tax-deferred savings in the context of the USA. We find that the contribution limit is not an effective tool in fostering retirement savings for all retirement savers. Increase in contribution limit benefits and encourages specific groups in saving. Savers with higher marginal tax rates, age, non-retirement wealth, and ability to borrow contribute more, if contribution limit is increased. Some of these findings are consistent with existing empirical findings, and have implications for policy decisions and tax-deferred plan design. In addition, our model indicates that contribution limit changes do not change asset location decision of the savers, but cause minor changes in asset allocation decision. Savers should locate highly taxable assets such as bonds in the tax-deferred account to save on taxes, and locate equities in the taxable account to take advantage of the capital losses, if any. In making, location decision saver should also pay attention to their retirement wealth level and liquidity constraint.