The Wrong Policy at the Wrong Time – Save the 401k Contribution
By Carol Buckmann, J.D.
America has a nationwide retirement savings gap. Some have even called the shortfall between retirement income and projected expenses a retirement savings crisis. Fidelity Investments says that you need to accumulate three times your income at age 30, seven times your income at age 55, and 10 times your income at age 67 to fund your retirement. Yet, more than half (54%) of pre-retirees are reported to have less than $150,000 in their 401k accounts.
At the same time that plan sponsors are trying to boost participation through education and plan design features, Congress is reportedly working at cross purposes with good retirement policy by considering a severe cutback to the maximum allowable pre-tax contribution.
From $18,500 to $2,400
The maximum pre-tax contribution for most participants is currently scheduled to go up to $18,500 in 2018. Employees who will be 50 or older by the end of the year may contribute up to an additional $6000 on a pre-tax basis. Congress reportedly wants to limit pre-tax contributions to $2400, a drastic decrease. While additional contributions would reportedly be permitted on a ROTH (after-tax) basis, the proposed decrease could dampen participation rates that had been climbing over the years.
Pre-Tax vs. ROTH Contributions
Under current law, employers are not required to make the ROTH option available, and Deloitte’s 2017 Defined Contribution Plan Survey says that only 70% of 401k plans permit ROTH contributions. If the plan permits ROTH contributions, eligible employees may choose whether to make contributions on a ROTH basis instead of a pre-tax basis, within the contribution limits. However, most have not been choosing the ROTH option. According to Willis Towers Watson, only 10% of employees who have the ROTH option take it. The Deloitte Report puts the percentage at 23%, but notes that ROTH participation rates have gone down slightly even though the percentage of 401k plans with a ROTH contribution option has increased.
ROTH contributions reduce dollar-for-dollar the maximum amount available for pre-tax contributions. This is an appropriate policy, because whether ROTH contributions make sense depends on the age of the employee and whether the tax rate after retirement will be lower than the current rate that employee pays.
Which Is Better – 401k or ROTH?
The key to making the right choice starts with understanding the ROTH contribution option. Although ROTH contributions are fully taxable when made, the contributions and earnings are not taxed when paid out – assuming that they have been in the plan for a minimum of 5 years and are withdrawn on disability or at or after age 59½. Payouts need to begin at age 70½, but it is easy to circumvent the rule by rolling the distribution into a ROTH IRA. Traditional 401k contributions are not taxed when made, but are taxed together with earnings when distributed from the plan.
For younger employees, the ROTH has clear benefits, including a long period of time for tax-free earnings to accumulate. As a group, younger employees will likely also be subject to a relatively low tax rate. For pre-retirees, the group we want to incentivize to keep contributing, the benefits are less clear. Older employees may currently have a tax rate that is closer to their anticipated post-retirement rate, and they have fewer years to accumulate tax-free earnings. If they lose their jobs, they may need to withdraw the money before they are 59½ or the 5-year requirement has been met, losing the tax exclusion. We can’t predict future tax rates, as Congress can always change them, which may deter some older employees from choosing the ROTH option.
Furthermore, the statistics on ROTH participation show that the benefits of ROTH contributions are not well understood. How many employers would undertake enhanced education efforts if the law is changed?
The Real Motivation
Congress is looking for ways to pay for a reduction in corporate tax rates, and the money has to come from somewhere. So why not collect the tax on 401k contributions now? This short-term gimmick eliminates individual choice and risks thwarting the long-term goal of increasing retirement savings.
What can we do to convince our elected officials this is a bad idea?
After initially tweeting that 401k contributions were safe, President Trump seems to have backed off from that assurance. The just-released draft does not scale back 401k contributions, but we should not be complacent. The draft is not written in stone.
The media have begun publicizing the threat to 401k contributions, but that may not be enough. Although proposals to scale back 401k contributions have been abandoned in the past, we shouldn’t assume that will happen again if those who would be hurt by this change do not speak out.
A concerted effort by everyone who would be affected by this proposal – including employees and those in the businesses of administering, investing and marketing 401k plans – is needed to convince Congress of the error of this approach. We need more letters and e-mails to our Congressmen and Senators, as well as industry group lobbying to head off this bad proposal.
Carol I. Buckmann, JD is the co-founding partner of Cohen & Buckmann, P.C. (www.cohenbuckmann.com). She is one of the top-rated employee benefits and ERISA attorneys in the U.S., and deals with some of the foremost issues in ERISA, including pension plan compliance, fiduciary responsibilities and investment fund formation.
The views expressed in this article are those of the author and do not necessarily represent the views of PenChecks Trust, its subsidiaries or affiliates.