The final tax bill heading for the President's signature raises IRA and employer-sponsored retirement plan annual contribution limits. This is excellent, long-overdue help for the minority of American investors who already make the maximum contributions.

But for the majority of workers -- low and middle-income earners either not covered by an employer-sponsored plan or who do not make maximum contributions -- the bill provides only a meager incentive to take scarce dollars and become investors for retirement.   

The main provisions of the bill are:

  • Increase the traditional and Roth IRA annual individual contribution limits from the current $2,000 to $3,000 through 2004, $4,000 from 2005 to 2007, and $5,000 in 2008.
  • Increase employee contribution limits for 401(k), 403(b), and 457 plans from the current $10,500 to $11,000 in 2002, and another $1,000 annually to $15,000 by 2006. The bill also applies Roth IRA principles to 401(k) and 403(b) plans, allowing employees to make after-tax contributions to those plans. Employers will have to keep separate accounts for employee traditional pre-tax contributions from new "Roth-like" after-tax contributions.
  • Taxpayers aged 50 and over can make extra, "catch-up," contributions. They can add another $500 a year to IRAs from 2002 to 2005, and $1,000 in 2006 and beyond. The catch-up for contributions to employer-sponsored plans starts at $1,000 a year in 2002 and increases $1,000 annually to $5,000 for 2006 and after.    

Contribution limits haven't changed since the 1980s, and the $2,000 limit for IRAs is stuck at 1981 levels. Depending on your inflation estimates, $5,000 in 2008 dollars would be worth about $2,014 in 1981 dollars -- a real increase of less than 1%, but better than nothing. The bill leaves IRA eligibility requirements unchanged.

More money, but what about more participants?
While all that is nice, what about the half of all private sector workers who don't have employer-sponsored plans and, on average, earn lower incomes? According to the Labor Department, pension plans cover only 6% of those earning less than $10,000 annually, versus 76% of workers earning over $50,000. Deductible IRAs are supposed to help, but they haven't worked to broaden retirement saving. In the last, most complete governmental study, the Treasury Department's Office of Tax Analysis found that 93% of taxpayers eligible for deductible IRAs made no contribution in 1995, and only 4% of those eligible made the maximum $2,000 contribution. 

Bottom line: Increasing contribution limits may only assist as few as 4% of eligible contributors to deductible IRAs.

A baby step in the right direction
The final bill departs from the House's version and takes a small step to increase those numbers. Congress adopted a progressive non-refundable tax credit, originally proposed by Rep. Dennis Moore (D-KS). This acts like the employer-matching contribution common to most 401(k) plans, and research shows that employer matches increase work participation.

According to Mark Luscombe, an analyst for tax information and software company CCH Inc., the bill establishes a temporary (2002-2006), non-refundable tax credit not to exceed $2,000 for contributions to an IRA or employee-sponsored plan. For joint filers with adjusted gross income (AGI) of no more than $30,000, the credit applies to 50% of the retirement contribution they make. A joint filer with an AGI of $30,000 to $32,500 can receive a 20% credit for retirement investments while a joint filer with an AGI between $32,500 and $50,000 can receive a 10% credit. Above $50,000, the credit is not available. The numbers for single filers are half of those for joint filers.

A refundable credit is better
The problem with a non-refundable tax credit is that the lower-income individuals and families most in need of the credit likely face little or no tax liability to begin with -- so they receive no benefit from the credit. A better idea is a refundable tax credit, advocated by The Center on Budget and Policy Priorities, a nonpartisan think tank that analyzes the effects of government policies on low- and middle-income people. 

Harvard Law School pension expert Daniel Halperin also thinks the refundable tax credit makes sense, and harkens back to the Clinton Administration's proposed USA accounts -- through which the government would have provided additional contributions on behalf of the lowest-paid.  

Not enough incentive for employers
The cost of administering pension plans and matching contributions likely means few employers would have the plans except as ways to attract and retain desirable workers. And because the most desirable workers are usually fewer and more highly paid, employers don't need to encourage broad participation by its workforce. The smaller the business, the more it pays for lower-paid employees relative to expenses for more highly-paid employees.

And the bill does nothing to address this problem. Its only effort is to introduce a credit of up to 50% of a small business' costs to set up a plan, but it's hard to see the credit as much of an incentive: It's limited to $500 annually and only for the first three years of the plan.

For those who can now contribute more, the tax bill is good news. It's a good -- no, great -- thing. But if we as a country are serious about providing non-Social Security alternatives for lower-paid workers, a refundable tax credit is a good way to help more workers become investors for retirement. 

Tom Jacobs (TMFTom9) just bought his first new suit in 12 years, for peanuts. With any luck, it'll be another 12. To see Tom's stock holdings, view his profile , and check out The Motley Fool's disclosure policy .