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As Republicans on Capitol Hill hammer out a tax reform bill, one controversial proposal would slash the annual amount Americans can sock away into 401(k) plans without being taxed until they retire. Do you have such a plan? Let’s look at how it would be affected.
First, some background: Although President Donald Trump has tweeted his opposition to altering the savings and investment plans, senior lawmakers from his own party — including House Ways and Means Committee Chairman Kevin Brady — have suggested that the tax bill could still include changes to 401(k) plans and other retirement accounts.
Modifying retirement plans would affect around 55 million U.S. workers, including many middle-class Americans.
Although lawmakers are at odds over which reforms should be prioritized, one of the few concrete ideas arising out of the Republicans’ tax discussions is the suggestion that the current cap on tax-deductible, voluntary retirement plan contributions should be cut dramatically — from $18,000 to $24,000 now, depending on a worker’s age — to $2,400.
That means that for participants in 401(k) and the similar 403(b) and 457 plans — popular employer-sponsored retirement opportunities — any contributions over $2,400 would be subject to taxes right away, rather than when the money is withdrawn as retirement income down the road.
To understand what this would mean to all of you who have accomplished wonders with your pre-tax voluntary contributions so far, here are the basics:
Today, the annual cap on tax-free 401(k) contributions is $18,000, plus a $6,000 annual “catch-up” contribution for people 50 and over.
Under the proposed reform, only the first $2,400 could be contributed as pretax dollars. The rest would be taxed up front.
There’s actually one advantage to that: Because you’re paying some tax now, you would pay less tax in the future when you withdraw most of the money — and its compounded earnings — for retirement income. The trade-off? You would no longer be able to use contributions above $2,400 to reduce your taxes now, as many people do.
Just as now, all the compound interest and earnings — the growth of your investments over time — would build up tax-free. But to understand how the devil is in the details, let’s look at what happens with a $10,000 contribution to a 401(k) now and under the proposed change.
For a single person, the combined federal and state tax bracket on income beyond about $40,000 is around 34 percent. For married couples, the 34 percent marginal rate comes in at around $80,000 of adjusted gross income.
Under today’s rules, a traditional, totally deductible 401(k) contribution of $10,000 annually reduces taxable income by the full amount. The single employee’s $60,000 taxable income becomes $50,000. That in turn saves them the 34 percent, or about $3,400 in taxes.
Under the proposed reform, if employees want to invest $10,000 in their retirement plan, they would have a choice. They could reduce their contribution to $6,600 and send the remaining $3,400 in taxes to state and federal governments, where it would be lost as an investment that could grow over the years. Or, they could deposit the full $10,000 in their 401(k) and prepare to write a check for an extra $3,400 in taxes that they otherwise could have avoided (meaning they’re ponying up $13,400 total).
In either case, the government gets some money today that it otherwise might have had to wait 30 years or more to receive. Generating tax dollars today is the engine driving policymakers to support the concept of taxing more retirement-plan contributions up front. Yet by doing so, the government would be forgoing a future potential tax-revenue windfall.
Meanwhile, the $3,400 paid in taxes has a far greater cost to you than just an annual tax hit. If the money had instead been invested in the 401(k) and compounded at a conservative 8 percent per year, it could build to $52,000 in 10 years, $166,000 in 20 years, and $421,000 in 30 years. This is the lost opportunity, magnified by the magic of compound interest, that we give up when we forego an opportunity to deposit pretax dollars versus post-tax dollars.
For participants, the tax-free income in retirement — from the contributions beyond $2,400 under the proposed change to 401(k) plans — wouldn’t offset that substantial cost. At worst, the ability to withdraw more of money in retirement without being taxed on the back end could be close to worthless.
That’s because the major, overwhelming expenses in retirement often involve nursing home care and other medically related expenses that are all deductible and offset what might have been taxes on income from conventional retirement plans.
At retirement, what’s important is to have as much money as possible. Adding the compound earnings of the tax savings creates as much as 50 percent more money in the nest egg for many people. The size of that egg contributes the most to financial security. The last thing any retiree cares about is whether they have to pay taxes on retirement plan distributions. What matters far more is having more money in the account, which pre-tax contributions deliver in spades, given the same investment results.
Bottom line: The concept of employer-sponsored voluntary retirement plans has been an enormously effective economic and social tool. They aren’t a bad deal for the tax man, either: Anything the government has postponed in tax collections is now beginning to materialize as participants retire or die and money is paid out.
Meanwhile, the $27 trillion in these plans partly explains the rise in stock market values and the unprecedented amounts of cash in the economy that help keep a lid on interest rates.
These plans have succeeded where traditional pension plans have failed. It is hard to imagine why tax reform proposals would limit, in any way, the contribution these plans make to our national wealth and individual financial well-being.