When House and Senate tax conferees convene to decide whether to preserve the deduction for Individual Retirement Accounts, some IRA investors won't be worried.
If tax revision takes away their IRA deduction, most of these 2.6 million dual savers would be able to add the money they would have contributed to their IRA contribution to their 401(k) savings plan run by their employer and still maintain their current level of tax deductions.
Someone now putting $4,000 annually into a 401(k) and $2,000 into an IRA for a total tax deduction of $6,000 could -- under certain conditions -- put $6,000 into the 401(k), thus preserving the same amount of tax deduction.
The loss of the IRA deduction would create an additional demand from workers for 401(k) plans, predicts Dallas Salisbury, president of the Employee Benefit Research Institute. "A lot of people will be able to put a sizable portion of what is now going into an IRA in their K plan with no obvious difficulty or expense for their employer," he said. Others who now enjoy the IRA deduction may try to persuade their employers to establish 401(k) plans.
The plans are set up by employers as a fringe benefit for workers and are regulated by the government to assure that all employes benefit from them, not just highly paid executives. More stringent requirements for 401(k) plans are included in the House and Senate bills. The current ceiling on employe contributions would be lowered from $30,000, or 25 percent of income, to $7,000. Whereas the House calls for keeping the ceiling at $7,000 indefinitely, the Senate wants to index it to the Social Security wage base, so fewer people will bump up against the limit.
Wealthy persons who already salt away $7,000 of their salary tax-deferred each year would not be able to increase the amount with IRA money. But 94 percent of the 9.5 million 401(k) participants now put in less than $7,000 annually, according to EBRI.
Both the House and Senate tax bills would permit Americans to continue putting money into their IRAs and allow the proceeds to accumulate on a tax-deferred basis. But surveys show the tax deduction, rather than retirement savings, is the primary reason people make these investments.
So conferees will be confronted by entreaties from both the grassroots and the financial services industry to preserve the IRA deduction for all. Should the lobbying fail, one potential compromise is to maintain the deduction only for persons with no other retirement plan and for those who are not yet vested in their company-sponsored plan.
Legislators favor the 401(k) plan, with its built-in antidiscrimination features, over the IRA, which some critics have described as primarily a device used by the rich to avoid taxes. However, some pension consultants believe the legislation will have the reverse effect of shriveling 401(k) plans because lower-paid employes will have little incentive to contribute to them.
The House and Senate have devised complicated formulas for deciding how much various groups of employes within a company can contribute in relation to the other. For example, the Senate would allow the top fifth of the employes on the wage scale to put away an average of 6 percent of income tax-free if the lower fourth-fifths put in, on average, at least 3 percent. For the top tier to contribute 13.5 percent, the other 80 percent of workers would have to contribute an average of at least 9 percent. By contrast, the House would allow the top to put in 11.3 percent only if the bottom contributed 9 percent of salary.
A recent survey by the Employers Council on Flexible Compensation found that the average top contribution rate that employers permitted workers was 8.3 percent. With that ceiling, actual payments to 401(k) plans amounted to just 5.4 percent.
According to EBRI's Salisbury, if lower-paid workers were to shift the same amount they are now contributing to their IRAs to their 401(k) accounts, the highly paid workers theoretically could do so as well if the wage differential between the two groups were not huge. He said a corporation could adjust its plan to allow workers to contribute more without incurring substantial cost to itself, because it would not be required to increase the percentage of contributions it matches. Typically, an employer will match 50 cents on the dollar up to a certain level, perhaps 2 or 3 percent.
Substituting 401(k) funds for IRA funds would not go against the spirit of tax reform, said Ed Davey, vice president of national benefits research department for Johnson & Higgins, pension consultants. A Ways and Means Committee aide said the potential tax-revenue loss from such shifts already was factored into the legislators' calculations on the impact of the tax-law changes.
However, Gary Pines of Towers, Perrin, Forster & Crosby, another pension consultant, said he doubted the shift would happen because the lower-paid workers would not be inclined to contribute. Two additional changes in the tax law would make the 401(k) unattractive for them: setting the minimum tax bracket at 15 percent and imposing a 15 percent early withdrawal penalty.
Tax deferral would become far less important when a deduction would be worth only 15 cents on the dollar. The 15 percent penalty would act as an additional deterrent to people who might want to use the money for college tuition or some other serious purpose before retirement. Then the effective tax rate on 401(k) distributions would be 30 percent. One would do better with after-tax savings.
To induce lower-paid employes to keep contributing, employers may have to increase their matching contributions or, in some instances, make contributions on behalf of the lower-paid employes to maintain the proper ratios with the higher-paid contributors. This, as well as the $7,000 ceiling and the 15 percent penalty, prompted Lloyd Kaye, a principal in William M. Mercer-Meidinger, benefits consultants, to predict that the current trend toward more 401(k) plans will reverse. That is just the opposite of what legislators intend.