As part of overhauling the U.S. income tax system, Congress is considering taking away the ability for you to reduce your taxable income through contributing to your 401(k). This has been discussed for some time and The New York Times reported on Oct. 20 that "House Republicans are considering a plan to sharply reduce the amount of income American workers can save" in 401(k) accounts reportedly to as low as $2,400 per year. (The current figure is $18,000, rising to $18,500 next year, with $6,000 additional in catchup contributions permitted to those 50 and over.)  However, President Trump tweeted, early on Oct. 23, that this will not happen.


What exactly will happen remains to be seen. Information on a new tax reform plan came out in a tax bill framework released on Sept. 27. (see Trump's Tax Reform Plan.) Congress is now starting to move forward on these proposals and much could evolve.

Looking back, President Trump's tax plan released April 26, also gave the impression that it would eliminate the tax break, as it only protected charitable giving and mortgage deductions, according to then White House Press Secretary Sean Spicer. The next day, the White House said that the plan would not remove the 401(k) contribution tax break, so this is not the first time the president has said that 401(k)s won't be hit. 

One version of the proposed change would make the taxation of 401(k) plans identical to the taxation of Roth IRAs and Roth 401(k)s. Instead of deferring taxes until the money is withdrawn in retirement, there would be no deferral and such withdrawals would be tax free. It's not clear what would happen if the amount you could defer would drop to $2,400, which is less than the $2,500 permitted for IRAs. (For more, see How Is Your 401(k) Taxed When You Retire?

How 401(k) Tax Deductions Work

Under current law, both Roth and non-Roth retirement plans allow investment earnings to grow tax free. While it’s no surprise that the Trump administration is working on major tax reform – a key component of Trump’s presidential campaign – it’s definitely a surprise to most people that the Republican-controlled Congress is considering eliminating one of the most popular tax breaks. 

Many taxpayers like being able to choose between paying taxes on their income now or paying taxes later, and many choose both by investing in a 401(k) and a Roth IRA to hedge their bets regarding future tax rates. On the one hand, 401(k)s and traditional IRAs could be the superior savings vehicles, based on the idea that workers’ current tax rates are probably higher than their retirement tax rates will be, because their incomes will be lower in retirement. But that belief not only assumes that workers will have lower incomes in retirement but also that tax rates will be similar to what they are today – a dangerous assumption. Hence the strategy of putting money in both types of accounts.

Losing the ability to hedge also puts savers at the risk of not getting all the tax savings the government has promised. Workers could start making all of their retirement contributions with post-tax dollars with the government’s promise that withdrawals after retirement age will be tax free. But future lawmakers could change that tax-free withdrawal provision as a way to raise more funds for a future cash-strapped government, just as they are now considering changing the tax-free-contribution provision of the 401(k). (For more, see Retirement Savings: Tax-Deferred or Tax-Exempt?)

Why Change 401(k) Taxation Now?

The Trump administration wants to lower tax rates and broaden the tax base. Specifically, it proposed cutting the corporate tax rate from 35% to 15% or 20%, wanted to cut the top marginal individual tax rate for the wealthy from 39% to 35%, and has recommended changing the current individual income tax system of seven brackets to a simpler system with three brackets. However, House Speaker Paul Ryan recently said he may propose a fourth, higher-than-35% bracket for the highest income earners.

Depending on which school of economic thought you support, cutting taxes has opposite effects: It either increases productivity and thereby increases individual and business income – which makes offsetting tax increases unnecessary to keep overall tax revenue the same or even increase it . Or, on the other hand, cutting taxes in one area necessitates raising taxes in another to keep revenue the same.

The "broaden the tax base" part means eliminating tax breaks to increase revenue. Making 401(k) contributions taxable would increase tax revenue by about $584 billion through 2020, according to calculations by the nonpartisan Joint Committee on Taxation. This tax break cost the government more than $90 million in 2016 says the JCT. Over the next 10 years estimates are that the government would increase tax revenue by $1.5 trillion by eliminating the 401(k) contribution tax deduction. 

Which Helps Revenue More: Keeping the Tax Break or Ditching it? 

The Bipartisan Policy Center, however, says that the JCT’s estimates are shortsighted – and its calculations are flawed – because they don’t accurately represent the true effect on the government of the current 401(k) system.The JCT uses a method that only looks at lost tax revenue in the near term. It doesn’t consider the revenue the government currently gets later when retirees withdraw 401(k) contributions and earnings, and pay taxes on them.

The Bipartisan Policy Center recommends using a net present-value score rather than a cash score to evaluate the long-run effect of changing 401(k) tax law. A net present-value score would include assumptions about “long-term interest rates, investment returns, the timing of account drawdowns, and the potential difference in marginal tax rates between when deferrals are made and when assets are drawn down in retirement,” writes Nick Thornton for BenefitsPRO, a website specializing in employee benefit and retirement data and analysis. 

Other Proposals for Changing 401(k) Taxation

Eliminating the 401(k) tax break isn't the only proposal on the table. Several others could also change retirement calculations.

One would allow half of 401(k) contributions to be made with pretax dollars while taxing the other half. Also included: eliminating the tax-deferred growth of 401(k) balances. Instead,  401(k) gains would be taxed at 15% annually. The latter change would make 401(k) plans a worse place to save for long-term investors than regular taxable accounts, where account holders only pay taxes on actual investment gains when they sell, not mere paper gains. 

The way changes in revenue resulting from changes in tax law are calculated is important, because congressional Republicans can pass a tax bill without support from the Democrats if they use a process called budget reconciliation. In order to use this process, any bills passed must not be projected to increase the federal deficit. 

Another justification for taxing 401(k) contributions is that if corporate income taxes go down, share prices will go up. Everyone who holds shares in their 401(k) would see an immediate increase in account value that would theoretically offset the tax increase. Presumably, any changes to 401(k) taxation would also affect traditional IRAs, as they are taxed similarly.

How Serious Is Congress About Changing 401(k)s?

Extremely popular tax breaks – think the mortgage interest tax deduction – tend to face strong opposition whenever they’re proposed. The same may prove true of any attempt to change 401(k) tax benefits. Attorney and former labor secretary Bradford Campbell told the Wall Street Journal that he thought retirement plan tax benefits would be reduced, but that it wasn’t clear by how much. Other sources told the Journal they weren’t sure how serious the administration was about 401(k) reform proposals.

Will Hansen, senior vice president for retirement policy at the ERISA Industry Committee, a retirement plan sponsor advocate, told BenefitsPRO that while he thinks the taxation of 401(k) contributions might change, he does not think that deferral limits will. As noted above, in 2017 taxpayers can place up to $18,000 in tax-deferred dollars into a 401(k). The new figure for 2018 is $18,500.

Ed Murphy, president of Empower Retirement, the country’s second largest 401(k) plan service provider, told BenefitsPRO that he thinks a hybrid solution is more likely than transforming the entire 401(k) system to a Roth system. Perhaps taxpayers will be allowed to contribute more, but with a lower cap on pretax contributions. 

Who Would 401(k) Taxation Changes Hurt?

Because individuals are much more likely to save for retirement if they have a workplace retirement plan – and because changes to 401(k) tax policy could discourage employers from offering 401(k) plans – changing the current 401(k) tax structure to a Roth tax structure will potentially hurt everyone.

People will save even less than the inadequate amounts they are already saving for retirement and have to work longer because they won’t be able to afford to retire. Their employers will potentially face higher healthcare costs for those employees, and older, higher-paid workers will stay on company payrolls longer, potentially reducing job opportunities for younger ones who command smaller paychecks.

Workers who are the least well off will be less able to afford to make retirement account contributions with post-tax dollars, so they may reduce their retirement account contributions.  Employers, aware that contributing to retirement has become more burdensome for employees, may reduce automatic enrollment or lower automatic contribution percentages in 401(k) plans, further reducing the individual savings rate. 

In addition, if Congress decides to tax the 401(k) plan contributions that employers make on behalf of employees, those contributions might decrease or disappear. The 401(k) might become a less attractive employment benefit overall, and employers who struggle with the time and expense of offering such plans – and who no longer receive a tax benefit from doing so – might cease to offer the plans altogether. Again, the result would be a lower individual savings rate and greater retirement insecurity.

A solution that proposes to increase tax revenue by taxing 401(k) contributions now instead of later is shortsighted. In the long run the government will not necessarily see additional tax revenue from this change; it will merely shift the timing of receiving tax revenue. The myopia of the current proposal raises the question of how the government might try to change retirement account taxation again in a decade or two, when it needs another major cash infusion. Will it eliminate the tax-deferred growth of account balances? Will it decide that Roth 401(k) and Roth IRA withdrawals must be taxed? Changing the rules on taxpayers mid-game at best is unfair and at worst financially destabilizing to both individuals and the country as a whole.

The Bottom Line

“Fixing our broken tax code is about having a simpler, fairer, and flatter tax system – not about increasing taxes,” states the Republican blueprint for tax reform published last June by Ways and Means Republicans. “This Blueprint will deliver a new tax system under which no income group will see an increase in its Federal tax burden. Furthermore, it envisions tax reform that is revenue neutral.”

It is possible that, combined with marginal tax-rate reductions, individuals’ overall tax bills could be the same even if the tax deferral for contributions to 401(k)s and traditional IRAs is lowered or eliminated. The question then becomes how changing the rules would affect savings rates.

Individuals are already saving far too little for retirement. Any change that discourages them from saving could worsen senior poverty rates and increase dependency on social safety nets and family members for basic support. And, of course, hardly anyone gets an old-fashioned defined-benefit pension anymore so 401(k) savings are ever more important for retirement security.




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