More than 62 million Americans — about a third of the nation's adult population — have put money into 401(k) retirement plans. Now Republicans in Congress are seriously debating changing the program, dramatically reducing the amount of money Americans can contribute tax-free to their 401(k) account from $18,000 a year now to just $2,400 a year. Does this make any sense?
Short answer: Changes are needed, but not like this.
The 401(k) is hardly a perfect retirement savings vehicle. It was originally designed in the 1980s to be a supplement to pensions plans, not the main way Americans save for retirement. Over the years, companies realized they could save a lot of money by dropping pensions, which guarantee a certain payout in retirement, and shifting to 401(k) plans, which require workers to shoulder the burden of saving their own money and investing it wisely. Herbert Whitehouse, one of the first to push for a 401(k) at his company in 1981, now regrets it.
Whitehouse, a former human resources executive at Johnson & Johnson, is one of many pointing out that the biggest flaw in America's current retirement system is that people aren't saving enough money (if they are saving at all). Just over half — 52 percent — of Americans have any retirement savings, according to the Federal Reserve, and the median amount put away for retirement is $60,000, not enough to live off for years. About everyone agrees that Congress — and corporations — need to find ways to spur people to save more. But the current proposal being tossed around by the GOP would do the opposite, experts warn.
“I think it will discourage retirement saving,” says Matthew Rutledge, a research economist at the Center for Retirement Research at Boston College.
At the moment, Americans under 50 can put up to $18,000 a year away tax-free in a 401(k), and people over 50 can put up to $24,000. The money can be invested in stocks, bonds or other funds. Over time, the money grows, creating a nice nest egg. People only have to pay taxes when they take the money out in retirement. Reducing the threshold to $2,400 is likely to dissuade some people from saving at all or saving more than that low amount, Rutledge says.
The main reason this idea is under consideration right now is not because Republicans are focused on improving retirement savings. Instead, they need money to pay for large tax cuts. The 401(k) tax break “costs” the government $71 billion a year in lost tax revenue, according to the Tax Policy Center, a think tank. Reducing the tax break is one way for the government to get more money, potentially over $700 billion in the next decade.
Another option is to “Rothify” retirement savings in America, meaning Congress would change the rules so any money that people put away for retirement above $2,400 would be taxed up front. This is how Roth IRAs (IRA stands for “individual retirement account”) work. People can only put after-tax dollars into Roth IRAs, though they don't pay taxes on money they withdraw later in life, as they do with regular IRAs and 401(k)s. It's a way for the government to get revenue sooner.
“I’m strongly against it as a budget gimmick,” says Marc Goldwein, senior policy director at the Committee for a Responsible Federal Budget, says of the 401(k) proposal. “It makes it look like we are raising revenue today when, in reality, we're just shifting tax money from tomorrow to today.”
Republicans are aiming to offset all but $1.5 trillion of tax cuts over the next decade, so the 401(k) proposal is an attractive one.
Congressman Kevin Brady (R-Tex.), chairman of the tax-writing Ways and Means Committee, is one of the main proponents of changing the 401(k) rules, a major disagreement with President Trump, who tweeted Monday that 401(k)s are a “great and popular middle class tax break” that he does not want to change.
“We think in tax reform we can create incentives for people to save more and save sooner,” Brady said to reporters at an event this week. “We are continuing discussion with the president.”
Brady argues 401(k) accounts aren't working, citing a Joint Committee on Taxation report that the median contribution is just $2,394 a year.
While 401(k)s are popular with 62.7 million active users in 2014, the last year the Employee Benefits Security Administration has released data for, they are used mainly by people earning over $75,000 a year. The Tax Policy Center concluded that 70 percent of the retirement tax benefits from defined contribution plans like 401(k)s go the highest 20 percent of earners.
“The Republicans are correct that the current tax treatment of 401(k)s and IRAs breaks disproportionately help the well off,” says Teresa Ghilarducci, an economist professor at the New School for Social Research and a longtime critic of 401(k)s. “The problem is the Republican proposal — which turns the current system into more of a Roth system — will favor wealthy people even more.”
If Republicans in Congress really want to get Americans to save more, there are three easy changes the government could make that are widely endorsed by many experts, including Richard Thaler, winner of this year's Nobel Prize in economics. The reforms are:
First, require companies to automatically enroll people into 401(k) plans.
Second, require people to be enrolled at a high rate (around 8 or 10 percent) or that their contributions automatically rise each year.
Third, offer lower income people some sort of subsidy.
People would have the ability to opt out or reduce their contributions at any time, but the biggest hurdle is that people don't start or they start too late in life. Thaler says most Americans need a good “nudge,” and the best way to do that is automatically enrolling them in 401(k)s.
“If you really want to get people to save, the one thing that really seems to work is to make it automatic,” says Rutledge of the Center for Retirement Research at Boston College.
What Congress is reportedly considering is the exact opposite. It would require the 62 million Americans who already tried to do the right thing and save for retirement via a 401(k) to fill out a lot of paperwork to switch to other plans, a barrier to saving. And lower income workers would not get any more help.