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Why Congress’s Plan to Slash 401(k) Limits Was Never a Good Idea

Donald Trump appeared to save a popular tax break for retirement savings, after the news broke that Congressional Republicans were considering sharply limiting the amount of pre-tax contributions American workers could make to retirement accounts.

“There will be NO change to your 401(k),” Trump wrote in an early-morning Tweet Monday. “This has always been a great and popular middle class tax break that works, and it stays!”

Lawmakers working on the long-awaited GOP tax plan reform were said to be considering a $2,400 cap on the amount of pre-tax dollars workers can contribute to a 401(k). Under traditional 401(k) plans, workers don’t pay income tax on those earnings before they are contributed. They pay taxes when they tap those savings in retirement, when they are likelier to be in a lower tax bracket. The alternative to a traditional 401(k) is a Roth; like a Roth IRA, contributions consist of after-tax dollars, but withdrawals are tax free.

That $2,400 cap would have been a significant departure from the current rule, which lets workers under the age of 50 contribute up to $18,000 before taxes, or up to $24,000 for workers 50 and older. Both of those limits were scheduled to rise by $500 each for 2018.

Personal finance and retirement-planning experts expressed concern that this would lead to a reduction in America’s already anemic retirement savings rate. What’s more, there’s a bigger problem with the GOP’s math, some experts say.

A delayed hit

If removing the tax-preferred status of much of the country’s retirement savings contributions leads to widespread conversion to Roth 401(k)s, where after-tax dollars are contributed but withdrawals are tax-free, the government could face a sharp drop-off in tax receipts when these workers hit retirement.

“They’re sacrificing future tax receipts,” said Nicole Smith, chief economist at Georgetown University’s Center on Education and the Workforce. “Thirty years down the line, who’s going to pay for this aging population?”

“What they proposed was really a budget gimmick. Down the road there’s going to be less tax revenue for the government,” said Len Burman, an institute fellow at Urban Institute Tax Policy Center.

And that could pinch the next generation of retirees. Mark Hamrick, a senior economic analyst with Bankrate.com, said most Americans don’t have nearly enough socked away as it is, and that nearly 40 percent of Baby Boomers say their biggest financial regret is not saving early enough for retirement.

“By and large, many Americans are failing to save enough for retirement, and one way to incentivize that is a tax benefit,” he said.

“It’s a huge disincentive to savings,” Smith said.

A 2016 report from the Transamerica Center for Retirement Studies found that only about one-third of those surveyed think they’re on track to have enough income in retirement.

“One thing we see in the research is most people say they don’t know as much as they should about retirement investing, and complexity makes it harder for people to save. What we don’t want to do is scare people off from saving, or create a deterrent to saving,” said TCRS president Catherine Collinson.

Vanguard’s How America Saves 2017 study found that the median amount workers put away last year was 5 percent, down from 6 percent in 2015. Vanguard said this drop is a side effect of more companies using auto-enrollment programs; these programs have grown by 300 percent since the end of 2007, Vanguard found. The default savings rate for these programs is typically low, perhaps 3 percent, so the flip side of greater participation is lower percentages.

At the median, a typical Vanguard retirement account contained $24,713 in 2016, a drop of 6 percent from a year earlier. If this sounds like it’s probably not enough, that’s because it’s not.

Behind the curve

Tim Herron, a senior partner in Aon Hewitt’s retirement consulting practice, said Aon’s most recent report found that Americans will need 11 times their annual income by the age of 65 to be financially comfortable in retirement, a goal only about one in five is on track to reach.

Aside from losing the up-front tax break, implementing a cap many workers would be likely to hit would require some kind of a two-tier or hybrid plan, which could be another roadblock that discourages people from saving.

“One of the overriding objectives is simplicity,” Herron said of retirement savings plan design. Too complicated, and people just stay on the sidelines, he said. “It’s sort of like it becomes paralyzing because it becomes harder to make a decision.”