Two high-profile economists recently stirred up controversy by recommending that the IRS eliminate tax-deferred contributions to 401(k) accounts. Sweeping changes are unlikely to happen anytime soon, and your nest egg isn’t in jeopardy of going away, so don’t panic about the headlines. Still, it’s important to understand the challenges and potential solutions that policymakers are facing as it pertains to retirement planning right now. That way you can build a rock-solid retirement plan that can thrive, regardless of future regulations.
Two economists made a bold recommendation
The American Enterprise Institute (AEI) published an article in January in which two economists made a case for eliminating the tax preferences on 401(k) contributions. This suggestion ruffled some feathers — these are among the most popular retirement savings tools, and Americans have around $7 trillion packed away in these accounts. The paper sparked discourse about the issues at hand and the best ways to fix them.
It’s not uncommon for economists at the AEI to argue in favor of deregulation or deficit-cutting measures. However, this article turned some heads because it was co-authored by Alicia Munnell, a high-profile professor, along with Andrew Biggs, a senior fellow at the AEI and former deputy commissioner for the Social Security Administration. The two have disagreed with each other publicly in the past, so this collaboration garnered attention.
The paper calls for a creative and drastic solution for the Social Security funding issue. The federal government’s guaranteed retirement income fund is cash-flow-negative, and the Social Security Trust is projected to be depleted by 2035. The shortfall is being driven by an imbalance between people paying in and people taking benefits from the system. These issues are expected to stabilize in the late 2030s, but there’s a serious threat to solvency in the meantime. At best, the cash buffer will be exhausted for future generations, leaving no margin of safety. In all likelihood, there will need to be some combination of higher payroll tax rates and reduced benefits to keep Social Security benefits safe.
Munnell and Biggs point out that 401(k) tax treatment costs the government nearly $200 billion in annual revenue. They suggest these funds would be better served supporting the Social Security system, increasing the guaranteed income received by future retirees.
The authors assert that the 401(k) tax treatment hasn’t had a significant impact on savings rates, and that the tax incentives disproportionately help high income earners. They argue that the tax policy didn’t achieve its intended goals, and that regulators should pivot to address the widespread shortfall in retirement savings before it turns into a national crisis.
To be clear, this isn’t a proposal to take away your existing 401(k) assets. If implemented, there won’t be an immediate tax bill or clawback of previous contributions. In fact, it’s unlikely that this policy gets approved at all. The authors probably know that, and the paper’s true intent might be to open new doors in public discourse about a serious issue that remains unresolved.
Why this could be important
There’s no sweeping change coming in the immediate future, but shrewd financial planners will recognize some of the ideas gaining traction. It’s widely accepted that future policy changes will be necessary, even if those changes are relatively modest. This paper serves as a warning about one potential solution that could be implemented in the next decade or two.
The conclusions and recommendations presented by Munnell and Biggs are somewhat radical, and they certainly generated pushback from fellow economists along with legislators and public figures. There’s a lot of resistance among economists to remove a popular tax benefit, limit personal control over retirement saving, and divert additional funds to a Social Security system that many academics regard as poorly run.
However, the bipartisan nature of the paper is noteworthy. Legislation with broader support, especially in such a partisan issue as taxation and wealth redistribution, is more likely to get implemented. People on both sides of the aisle have reasons to support this, and that gives it some legs. When legislation is eventually passed, it could be influenced by some of the ideas being proposed today.
What it means for your retirement plan
If you’re utilizing a 401(k) right now, keep doing it. Most financial planners support 401(k) contributions at least up to the maximum contribution match provided by your employer, provided that it’s not putting undue strain on your financial plan otherwise. Most people benefit by delaying taxation until retirement, when they are in a lower bracket. If that benefit is at risk of being removed, it’s probably a good idea to take full advantage during your peak earning years.
Earners in high tax brackets should also consider making contributions to traditional IRAs, which receive the same treatment as a traditional 401(k). The deductible amount might be limited by your 401(k) participation or income, but many households can still participate in these accounts.
The new proposals also serve as reminders that you can save for retirement outside of tax-deferred accounts. Roth IRAs are great vehicles for growth investments, since they remove any taxation on returns. You can also accumulate wealth by investing in brokerage accounts. These won’t provide meaningful tax benefits, but they do offer liquidity and flexibility that aren’t available with other retirement accounts.
Finally, this is also a stark reminder of the threats to Social Security. Future generations are almost certain to receive Social Security benefits, but they might cover less of the average household budget than they do now. Being self-sufficient is always preferrable, so you should strive to save at least 15% of your annual income. Spreading those savings across multiple investment accounts is a great way to give you options when you need to withdraw funds to meet cash needs.
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Should the Government Get Rid of 401(k) Accounts? How You Should Prepare in Case These Economists Get Their Way was originally published by The Motley Fool
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