UPDATE: Congressional Republicans (and Maybe Donald Trump Too) Could Be Coming For Your 401(k)
Tax reform will change how Americans save for retirement, but lowering a tax deduction for 401(k) savings would be a fiscal and political misstep.
House leaders say a bill will rewriting the federal tax code will be released tomorrow. One idea reportedly being considered for it could imperil a key incentive to save for retirement.
President Donald Trump and Republican leaders in Congress had promised not to mess with how 401(k) plans operate or to change the current tax deduction for contributions to those retirement accounts. Last week, however, the president suggested that he may be willing to ignore that promise. "Maybe we'll use it as negotiating," Trump said.
If nothing else, that demonstrates the difficulties Republicans have had in passing major legislation. Saying publicly that you might use something as a negotiating tactic is, in fact, not a great negotiating tactic.
And politics aside, rolling back 401(k) deductions is a bad idea on the merits.
Any comprehensive tax reform plan is going to have significant consequences—both intended and unintended—for how Americans save for retirement. The very existence of 401(k) retirement plans is, in fact, one of those unintended consequences. That section of the tax code was written in the 1970s as a special favor to high-earning executives who wanted to avoid taxes on the part of their income that they invested in the stock market. In 1980, Ted Benna, a retirement consultant working for The Johnson Companies, realized that any employee could use that same provision to make investments with pre-tax dollars, and the 401(k) retirement plan was born. Today more than 55 million American workers have 401(k) retirement plans containing over $5 trillion in savings, according to the U.S. Department of Labor.
Under current law, workers can contribute up to $18,000 a year to their retirement plans, tax-free. So if someone earning $100,000 a year, subject to a 28 percent federal marginal tax rate, contributes $10,000 annually to a 401(k) plan, she reduces her taxable income to $90,000 for the year. That level of income is taxed at 25 percent by the federal government, so the worker's tax liability (absent other deductions and credits) would drop from about $21,000 to around $18,000.*
According to data from the Congressional Joint Committee on Taxation, as reported by The New York Times, the 401(k) tax break cost the federal government more than $115 billion in revenue during the current fiscal year. As Congress mulls a $6 trillion federal tax cut, some legislators—includinRep. Kevin Brady (R-Texas), who chairs the key House Ways and Means Committee—have been eyeing 401(k) contributions as a way to "pay for" tax reform. Lowering the threshold for tax-free retirement contributions, potentially to as low as $2,400 a year, would allow Congress to offset tax cuts elsewhere.
[Update: ABC News, citing sources familiar with the tax bill, reports that the proposal would "lower what individuals may contribute tax-free to their 401(k)s, to an amount about halfway between the current limit and what House Republicans initially proposed."]
There is, of course, a better way to "pay for" tax cuts: Cut spending.
Lowering or eliminating the 401(k) deduction will likely make it harder for workers to save for retirement, something many Americans are already struggling to do. While 401(k) plans have hit record levels in recent years, the average account holds less than $100,000—an inadequate amount for an individual's retirement.
Unlike tax breaks that benefit only a small set of individuals or businesses—or even more broad-based tax breaks, like ones targeted for homeowners and children—the exemption for retirement savings helps just about everyone. Aging isn't a choice, and retirement is something that virtually everyone hopes to enjoy.
Rationally, people should be motivated to save for retirement whether they are getting a tax break to do so or not. Unfortunately, that's not necessarily how many people think.
"This is going to eliminate one of the major incentives that people have to save, which is to avoid paying taxes," says Daniel Rickett, president of Capital Street Financial Services. Rickett warns that lowering the 401(k) deduction threshold would have knock-on effects that Congress may not be expecting. Less money, for example, would be invested in the stock market.
Private retirement savings are essential, since government options such as Social Security are unlikely to cover most retirees' living expenses (and may not even exist at all by the time younger workers retire). Private-sector workers are trying to save for their own retirements while also funding the retirement accounts of public employees, who are owed more than $1.5 trillion in unfunded benefits over the next few decades. Congress isn't considering new taxes on public workers' retirement income, but instead is targeting private-sector employees who are already hampered when it comes to saving for retirement.
Lowering the threshold for pre-tax contributions to 401(k) plans is part of an overall Republican strategy to encourage more Americans to use Roth IRAs, which are funded with after-tax dollars and grow tax-free. Roth IRAs are often a good investment tool for retirement, but lowering or removing the 401(k) deduction essentially forces all Americans to use Roth accounts instead of other options that might be better in individual circumstances. Consider the hypothetical worker we discussed earlier: Instead of saving $10,000 and getting a $5,500 break on her tax bill, she would have to pay the full tax amount and then save part of what's left over in a Roth account.
Republicans also stand to lose politically by going after the 401(k) deduction. The tax bill has yet to be introduced, but Democrats have already pounced on the possible change. "Families today are already not saving enough for retirement, and we are concerned that mandating Roth savings will diminish their ability to save even further," wrote a group of five Democratic senators in a letter sent last week to Republican leaders negotiating the tax reform plan. "Those with limited discretionary income will need to reduce their current level of saving to afford the immediate taxes due on their savings, or they will need to reduce other necessary spending."
*The original version of this article misstated the potential tax savings in this hypothetical scenario. Thanks to several readers who pointed out the error