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How do tax breaks affect retirement funds?

November 26, 2012

Over the years, tax breaks have emerged as one of the best ways to save money for retirement. With Harvard researchers reporting that the U.S. Government spent more than $100 billion on these tax subsidies each year, it may seem like adults leaving the workforce will have their retirement cost of living easily covered. A new study, however, is suggesting that, despite the government's best efforts, tax breaks actually bear little effect on the amount that seniors actually save for retirement.

Titled "Active versus Passive Decisions and Crowd-Out in Retirement Savings Accounts," the study followed the savings trends among retirees in the top tax bracket in Denmark, a nation with a similar pension program to the U.S. and more detailed financial records on this matter. The research is currently being submitted to academic journals, and researchers have been presenting their findings at academic seminars throughout the U.S. and abroad, according to The New York Times.

The study, which incorporated research performed by faculty at Harvard, as well as the University of Copenhagen and the Danish National Center for Social Research, claims that every dollar that a government spends on tax breaks increases affected individuals' savings by only a single cent. Though tax breaks on IRAs and 401(k)s did initially impact savings totals, researchers found that these individuals began to reduce the amount they saved outside of their retirement accounts, effectively offsetting any gains these plans may have afforded them.

This stands in stark contrast to findings that suggest policies that automatically deduct funds from a retiree's income improved their savings at a more significant clip. Individuals with higher automatic employer pension contributions nearly double. Researchers believe that these statistics stem from an individual's tendency to save passively, meaning the increased company contributions bear little impact on the amount of savings appearing in other accounts.

"The findings reported here call into question whether subsidies are the best policy tool to increase retirement savings," claim study authors, as reported by the Times. "Our findings strengthen recent arguments for using 'nudges' such as automatic payroll deductions or savings defaults to stimulate retirement savings instead of subsidies."

Researchers suggest that adults nearing retirement take a more active approach to their savings plans, researching different plans and pensions that can help seniors with retirement home costs, fixed expenses and other financial challenges that may be on the horizon.