As Congress and the Trump administration pursue their goal of reforming the U.S. income tax system, much attention has been focused on potential changes to 401(k) retirement plans. What does this mean for you?
Well, no one knows for certain. The tax-reform plan is anything but finalized, and no bills or even drafts have yet been made public. But beginning with a September Politico article about behind-the-scenes progress on tax-reform goals, there has been much analysis and, yes, tweeting, about implications for 401(k) plans and Americans’ retirement savings habits. (See also: What is a 401(k)?)
Here’s a review of what we know, and why it’s important for virtually all Americans:
The crux of the matter concerns the potential reduction or elimination of the tax-deferred status 401(k) plans have enjoyed since their debut in 1980. The IRS currently treats 401(k) savings as pre-tax income: Any funds you stash in your 401(k)—or that your employer makes in the form of a matching contribution—in a given year do not count as income you must report on that year’s tax return. You don’t pay income tax on your 401(k) savings until you withdraw the funds—typically when you’re retired, and your income and income tax rate are lower than they are during your working years.
If you have a 401(k) plan, current rules allow you to save a total of $18,000 each year in combined personal savings and employer matching funds. If you’re 50 or older, you can save even more—up to $24,000 annually. The ability to reduce your taxable income by that much is a major tax break for most Americans.
It has been widely reported that members of Congress are considering reducing the maximum tax-deferred 401(k) contribution to $2,400. In that scenario, you’d be able to save larger amounts—and receive employer matches on them—but savings in excess of $2,400 would be taxed as current income, and would have to be placed in a separate account similar to a Roth IRA. For this reason, some pundits refer to the possible change as “Rothification” of 401(k) plans. (See: What Is a Roth IRA?)
What’s the impact?
It’s impossible to say how the rumored changes could affect families and individuals, since any change in 401(k) taxation would be part of a bigger plan encompassing tax rates, deductions, and other rules. But on its own, making most or all 401(k) savings taxable would increase many Americans’ tax exposure.
Proponents of the idea argue it would pump millions of dollars into the government’s coffers, helping offset the deficit-inducing impact of proposed cuts in both corporate and individual tax rates. Critics argue that treating 401(k) savings as taxable income could effectively reduce the amount affected taxpayers have to save, and it will make employer-sponsored retirement savings programs less attractive.
That’s a big deal, because since their introduction in 1980, 401(k) plans have steadily gained popularity, displacing once-traditional pension plans as the most widely available employer-sponsored retirement-benefit programs available to Americans. A study published in August 2017 by the Employee Benefit Research Institute describes 401(k) plans as the most widespread private-sector employer-sponsored
retirement plans in the United States. By the end of 2015, the last full year for which data was available for the study, approximately 54 million American workers were participating in 401(k) plans, and their collective funds held more than $4.4 trillion, or 19% of all U.S. retirement assets.
What’s more, according to the nonpartisan Economic Policy Institute, Americans’ current 401(k) savings levels are insufficient to meet future retirement needs—a problem that could worsen with disincentives to use the plans.
What are the odds?
The likelihood that the 401(k) tax break will be reduced or eliminated is hard to gauge, in part because of mixed signals from the White House.
President Donald Trump tweeted Oct. 23 “There will be NO change to your 401(k). This has always been a great and popular middle class tax break that works, and it stays!”
There will be NO change to your 401(k). This has always been a great and popular middle class tax break that works, and it stays!
— Donald J. Trump (@realDonaldTrump) October 23, 2017
But a few days later, he indicated he was open to negotiation on that point after Rep. Kevin Brady, the majority whip and chair of the House Ways and Means committee, contradicted Trump’s “no change” statement from two days earlier.
Tax reform legislation is intrinsically complicated, and it’s likely there will be much wrangling and negotiation before Congress even has a bill to debate. No one can say whether 401(k) plans will be affected, but the fact that their tax-deferred status is even up for consideration is historic. If you’re one of the 54 million Americans who participate in a 401(k) plan, you’ll definitely want to keep an eye on the issue.