I gasped when I read this week that House Republicans may tinker with the hugely popular 401(k) retirement benefit as part of their tax reform package.
The idea would raise billions of dollars, presumably by removing the deduction that 401(k) savers get by taking $18,000 off the top of their salary before income tax kicks in. People over 50 can put in another $6,000, called a “catch up” contribution, also tax free.
In effect, Congress would be converting 401(k) plans going forward into something resembling the Roth Individual Retirment Account.
Roth IRA’s are a special retirement account for workers who qualify where you pay taxes on money going into your account and then all future withdrawals are tax free. Keep in mind that any gains you get over the years, thanks to the glories of compounding interest, in both 401(k)s and Roth IRA’s are tax free.
I love my 401(k). I will be 62 in a few weeks and have spent the past three-plus decades preparing for retirement by plowing as much money as I was legally allowed by the Internal Revenue Service into my 401(k). My wife and I are able to reduce our income, and thereby reduce our taxes, and watch as the money compounds tax free. The bill comes due in the form of income tax once we begin drawing down our 401(k) in retirement.
Millions of other Americans have been doing the same.
An estimated $5 trillion is held in 401(k) plans, according to the Investment Company Institute, which represents the mutual fund industry. That’s nearly 20 percent of the total amount of U.S. retirement assets.
The 401(k) program, which began with the Revenue Act of 1978, has a mixed bag of supporters and critics. Some say the tax-deferred accounts are incredibly successful at encouraging Americans to save for retirement. Critics say it favors wealthier people who can afford to save and get a nice tax break while leaving behind low-income workers who cannot afford to do without the cash now.
One of the key issues since the onset of the 401(k) program has been encouraging people to participate. The financial industry, not surprisingly, is a big supporter of the current design.
Investment Company Institute chief spokesman Mike McNamee said his group “strongly supports preserving the current system of tax deferral, which has encouraged millions of Americans to save for retirement.”
The ICI cited a study that found 91 percent of retirement account holders, including 401(k) participants, believe the current, up-front payroll deduction “makes it easier for me to save.”
Some others say removing the up-front payroll deduction on 401(k)s would not have a big effect on participation. Many savers in the plans don’t understand the differences in the tax consequences between the 401(k) and Roth-based accounts, according to one study.
“The evidence suggests that there will be relatively little impact on 401(k) participation and contribution rates if we switched to a Roth-only system,” said James Choi, a professor of finance at the Yale School of Management who has done research on the subject.
“In large part,” Choi said, “people don’t understand how 401(k) taxation works.”
He cited one survey in which only 49 percent knew that making before-tax 401(k) contributions decreases taxable income in the year of the contribution. Only 46 percent responded that making Roth 401(k) contributions does not affect taxable income in the year of the contribution, Choi said.
One possible advantage of paying the tax up front is that you meet the obligation based on your current tax rate instead of owing based on a future rate that could be higher by the time you retire.
Andrew Biggs, a resident scholar at the American Enterprise Institute, a Washington-based think tank favoring free markets, said the biggest issue for 401(k)s is signing people up.
“Some people may like paying upfront with the tax-free withdrawals, while others might like the tax savings today,” Biggs said. “But this isn’t as big a deal as something like automatically enrolling people in 401(k)s. That’s a major effect, while the tax treatment is more around the margins.”