Employers must prepare for a 401(k) contribution cap
Congress has said it will drastically cut the amount of money Americans can sock away in their pre-tax 401(k) plans as part of its tax reform proposal, but President Donald Trump tweeted that tax reform would not impact 401(k) plans.
The retirement industry is not sure who to believe and is gearing up to fight any proposal that drastically limits the amount of pre-tax money Americans can save for retirement. Currently, workers can save up to $18,000 a year in their workplace-sponsored retirement accounts, and people over age 50 can stash away $24,000 a year pre-tax.
The rumor this week has been that Republican Legislators plan to reduce 401(k) plan contribution limits to $2,400 annually, forcing most people to put their savings away in after tax vehicles like Roth IRA or Roth 401(k) plans. The move would save the government billions of dollars over the next 10 years and enable Congress to pay for large business tax breaks in the short-term. But critics have pointed out that that plan essentially kicks the can down the road because the government typically gets its taxes on that money when people retire instead of before they retire.
“The retirement plan, America’s piggy bank, has always been the first go to place Congress goes to when it needs money to pay for other tax breaks,” says Diane Oakley, executive director of the National Institute on Retirement Security. “You can look back over 20 or 30 years and see these situations. Some of them are gimmicks, like the Roth concept that was introduced to pay for tax benefits by shifting tax liability to current days to generate revenue, yet making a much bigger tax benefit available, especially to higher income people.”
She adds that if Congress caps the contributions individuals can set aside in their 401(k) plans at such a low level, this will only exacerbate the current retirement crisis where US workers do not save adequately for retirement. “I am extremely concerned. They really need to save consistently and, ultimately we will get a whole generation of retirees who are less adequately prepared than people are today. About six out of 10 households are not on track to maintain their standard of living in retirement,” she says.
If workers head into retirement with less money saved up, it means that more elderly will tap into the social safety nets such as housing assistance, food stamps and heating assistance, she adds. They also will work longer and spend less, which will not help grow the U.S. economy.
“It is very short-sighted,” Oakley adds.
Dave Gray, senior vice president, retirement products leader for Fidelity Investments, says that Fidelity is “very supportive” of a pro Roth and pro investor tax reform package. “We think a growing economy and growing business environment are foundational to retirement security for American workers. We also understand that Congress my look or may need to find revenue to pay for tax reform,” he says.
Gray adds that, “we think the pre-tax deferral system should not be used to pay for tax reform, but if Congress chooses to go there, we think a partial Roth system with a $9,000 to $12,000 pre-tax deferral cut off is better than full Rothification or a pre-tax limit that is very low, like $2,400.”
Lowering the contribution limit to $9,000 a year would only negatively impact 17% of plan participants and could raise $100 billion in revenue over the 10-year scoring period for the budget reconciliation process, Gray adds. If Congress capped contributions at $12,000 a year, that decision would only negatively affect 12% of participants and raise closer to $60 billion.
Exceeding the limit
The Employee Benefit Research Institute released 2015 data showing that 38% of those earning between $10,000 and $24,999 per year, who contribute to a workplace plan, exceeded the proposed $2,400 contribution limit for 401(k) contributions. For those making $25,000 to $49,999 annually, 32% contributed more than that threshold in 2015. The numbers nearly double to 60% in the $50,000 to $74,999 income level.
So even the lowest wage levels of 401(k) contributors would be impacted by the $2,400 cap, EBRI said in a statement this week.
“For those with more than $100,000 in wages, 87% would be impacted,” EBRI found.
EBRI notes that its data doesn’t describe how Rothification, with or without the $2,400 threshold, would impact retirement income adequacy.
Oakley says that Congress is ignoring other key points in its quest to pay for tax breaks. One is that small businesses would be hurt by the proposed cap. Currently, small employers are incentivized to offer workplace retirement plans because they, as business owners, are able to set aside the maximum in pre-tax retirement savings for themselves, as long as they offer a plan to employees of all income levels. If that incentive is taken away, many small businesses will stop offering plans or will only contribute the 50% match they typically do now. The difference is that that 50% match would be on $2,400 instead of a much higher employee contribution, she says.
Most financial institutions recommend that individuals save 15% of their pay for retirement. They agree that this is the best amount to ensure workers can maintain their current lifestyles in retirement.
A person making $40,000 a year typically sets aside 6% in their 401(k) plan to take advantage of the full employer matching contribution. That would put their pre-tax retirement plan contribution at about 9% of pay, which would replace one-third of their final salary in retirement. The problem that arises with the $2,400 cap proposal is that a worker earning $80,000 a year would only be able to set aside 3% of their salary pre-tax. The employer matching contribution would only be 1.5%, setting them up to replace only 17% of their final salary in retirement, Oakley adds.
“We have 32 million people working for small employers who don’t have access to a pension through their employer. That is the most important stepping stone to getting people to save and save an adequate amount,” Oakley says. “This will hinder access and could have a significant impact on adequate savings, especially on middle income families.”