Pressure is growing to change incentives for retirement savings as U.S. lawmakers look for revenue, and top earners may pay the price.

The budget challenges confronting the federal government are leading to scrutiny of tax-advantaged savings accounts such as 401(k)s because they’re among the costliest tax breaks. A recent Brookings Institution report adds to research that recommends curtailing the benefits for top earners to boost U.S. coffers.

“We really need to think hard about whether the dollars we are spending are effective at achieving the goals,” says Karen Dynan, co-director of the economic studies program at Washington-based Brookings and author of the report. “Our existing programs are falling short.”

The shift from pension plans, which typically guarantee income for life, to tax-deferred 401(k)s has put more responsibility on savers to ensure they don’t run out of money in retirement. As the accounts have grown -- Americans held $3.5 trillion in 401(k)s as of September -- they’ve become a target in deficit-reduction talks because contributions usually are invested and compound on a pretax basis.

The benefits reward higher earners who would save anyway while not providing enough incentive for low and middle-income earners, according to Dynan.

Capturing revenue

Individual retirement accounts, which many workers roll their 401(k) savings into when changing jobs or retiring, also benefit from tax deferral. IRAs held $5.3 trillion in assets at the end of the third quarter of 2012, according to the Investment Company Institute, the mutual fund industry trade group.

Withdrawals from 401(k)s and IRAs eventually are taxed at ordinary income tax rates of as much as 39.6%, compared with top capital gains rates of 23.8% on investment income.

The benefit for 401(k)-type plans is the U.S. government’s third-largest tax expenditure, behind only the mortgage interest deduction and exclusion of employer contributions for medical insurance. It is estimated to cost about $429 billion in forgone revenue from 2013 through 2017, according to the administration’s latest budget proposal. IRAs will cost about $100 billion over the five-year period.

The latest ranking is scheduled to be released as early as next month and will reflect changes in tax law as of Jan. 1.

Fiscal deadlines

Dave Camp, a Michigan Republican and chairman of the House Ways and Means Committee, has said the panel will advance a rewrite of the tax code this year after scrutinizing all breaks.

Jack Lew, Obama’s nominee for Treasury secretary, said during a confirmation hearing Feb. 13 that improvements can be made to 401(k) plans.

“They’ve worked better for people at the higher end of the income scale than people in the low-to-middle end,” Lew said. Now confirmed, Lew is one of the administration’s top negotiators with lawmakers as Congress considers a rewrite of the tax code.

Capping deductions

Obama proposed a 28% cap on the value of top earners’ deductions such as retirement savings that wasn’t adopted last year. Republicans control the House and can block legislation from advancing in the Senate.

Top earners and their retirement savings were considered by Democrats as recently as this month as they drafted a plan to avert the automatic cuts. A proposal to limit taxpayers from putting more money in accounts such as 401(k) plans once a balance reached $2 million wasn’t included, a Democratic aide who asked not to be identified said at the time.

The current incentives encourage wealthy households to shift money into tax-deferred accounts rather than taxable ones, generally without increasing their savings rate, Brookings’ Dynan says. Low-income households most at risk of outliving their savings don’t receive as much of a benefit because they’re taxed at lower rates, she says.

Tax breaks

To improve the system, the government should expand tax breaks so more small businesses set up retirement plans for their workers, revamp savings credits for low-income workers, expand access by establishing an automatic IRA program and cap the value of tax deferral in retirement accounts at the 28% bracket, Dynan says.

The limit on the tax benefit for high earners would reduce the budget deficit by about $7.5 billion in the first year, while all of the proposed changes would mean a net reduction of about $4 billion, according to the study.

Dynan’s proposal is part of a budget report being released by the Hamilton Project at Brookings tomorrow. The project’s director is Michael Greenstone, a professor of economics at the Massachusetts Institute of Technology and Obama’s former chief economist for the Council of Economic Advisers.

Overcome penalty

A 28% cap means those in the top bracket would pay an 11.6% tax on their contributions up front and then 39.6% in income taxes when they take the money out, says Peter Brady, senior economist at the Washington-based ICI. Top earners invested in a stock fund returning 6% a year would have to hold the investment for 16 years to overcome the penalty, according to Brady’s analysis.

“Some people in the top brackets will decide they are better off taking the money and putting it in a taxable account,” he says. That would result in fewer employers offering 401(k) plans as they decide it is no longer cost- effective, Brady says.

The deferral encourages people to save because they can get a higher rate of return over time as the principal grows untouched, he says.

National and state legislators have proposed changes to the retirement-savings system beyond the tax breaks to increase savings rates.

Sen. Tom Harkin, an Iowa Democrat and chairman of the Senate Health, Education, Labor and Pensions Committee, plans to introduce legislation this year to require businesses that don’t offer a pension or 401(k) plan with a company match to automatically enroll workers in a so-called USA Retirement Fund.

About 68% of workers had access to retirement benefits as of March 2012, according to the Bureau of Labor Statistics.

‘Getting fainter’

“The dream of a secure retirement is getting fainter and fainter,” Harkin said Feb. 12 in a speech at the Center for American Progress in Washington. “Savings rates are low and there’s no simple way for people to convert their savings into a stream of retirement income they can’t outlive.”

Tax incentives for retirement savings are vulnerable as lawmakers look for revenue and consider whether the system encourages those to save who most need to do so, says Derek Dorn, a partner at Davis & Harman LLP in Washington whose firm lobbies for clients including some mutual-fund companies.

“There’s a scramble for revenue going on,” he says. “Questions are being asked that just a few years ago weren’t being asked of the system. There is a potential that the existing landscape could be altered.”

To contact the reporter on this story: Margaret Collins in New York at mcollins45@bloomberg.net

To contact the editor responsible for this story: Jodi Schneider at jschneider50@bloomberg.net

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