This week there has been a lot of discussion about the forthcoming Republican tax reform plan. In particular, there has been significant coverage of President Trump’s tweet about 401(k)s and protecting their current tax status. The president’s tweet has prompted a much needed discussion about 401(k)s and how much they help the middle class save for retirement.
The Republican tax plan aims to cut taxes by about $1.5 trillion over ten years. Due to budget rules in the Senate, those tax cuts have to be offset either by spending cuts or by increasing revenue elsewhere to prevent increasing the federal deficit. One way to cut taxes while still bringing in revenue is to “broaden the base and lower the rate.”
A major reason the U.S. tax code is so complicated is because there are many tax breaks and loopholes for specific purposes. Tax experts call these “tax expenditures.” The federal government loses money (sometimes called spending through the tax code) in order to promote a specific cause, such as charitable giving, homeownership, or saving for retirement. If all of these tax expenditures were eliminated, the federal government would collect a lot more money through taxes. Congress could then cut tax rates while still collecting the same amount of money it currently collects. The tricky thing about tax reform is there are a lot of people who like the tax expenditures that they benefit from now. Every tax break and loophole has at least one group that supports it and will fight to protect it during tax reform. Thus, Republicans are in a tight spot of needing to reduce or eliminate tax expenditures so they can lower the overall tax rate, while not provoking the wrath of powerful interest groups who want to protect their tax benefits.
Republicans also only have to account for the impact of tax reform within a ten year budget window. This is critical to understand when it comes to the debate over retirement savings. Again, due to Senate budget rules, the tax reform legislation will be evaluated based on how it impacts the federal budget over the next ten years. The effects on the federal budget beyond ten years are not assessed. Therefore, Republicans just have to say their plan doesn’t increase the deficit within the next ten years.
What Congressional Republicans are considering for 401(k) plans is dramatically lowering the amount of money that employees can contribute to their 401(k) before taxes each year. Currently, workers can contribute as much as $18,000 pre-tax to their 401(k). The Republican proposal would lower this to just $2,400 each year. It is important to note that very few people contribute the maximum amount to their 401(k) each year. Furthermore, the favorable tax treatment of contributions to 401(k) plans disproportionately benefits the wealthy over the middle class.
Why do Republicans want to lower the cap on 401(k) contributions so dramatically? Because changing the way 401(k) contributions are taxed today frees up a significant amount of money to use to lower the overall tax rate. For 401(k) plans and traditional IRAs, money is contributed pre-tax but is then taxed as regular income years from now when the individual withdraws the money in retirement. This means that the federal government loses money in the short-term but gets that money back in the long run. For Roth IRAs, the money is contributed after taxes now but is never taxed again. This means the federal government gets the money now, but loses money in the future. Lowering the cap on 401(k) contributions would have a similar effect. If Congress lowers the cap on 401(k) contributions, they get more money now, which helps them pass their massive tax cuts. It doesn’t matter that the federal government will collect less money in the future; those losses will occur outside the ten year budget window.
Congressional Republicans have a very short term interest in lowering the cap on 401(k) contributions. However, there are important reasons why lowering the cap could harm retirement savings among middle class families. As stated above, very few middle class families make the maximum contribution to their 401(k) each year. According to the Center for Retirement Research, only 36 percent of workers making more than $100,000 per year maxed out their 401(k) contributions; among workers making between $75,000 and $100,000, only 6 percent maxed out. So why would it matter if the cap was significantly lowered? Because people might use the new cap as a guide for how much to save for retirement each year.
According to Brigitte Madrian, a behavioral economist at Harvard’s Kennedy School, individual workers might not understand the intricacies of the tax code, but they take cues from what they know. If the cap on contributions is lowered to $2,400, workers may view that as the amount that they should contribute each year and they might not make any contributions above that. This is a serious threat to retirement security because saving $2,400 per year is not enough for most middle class families to accumulate adequate savings in retirement.
Tax reform promises to be a long and complicated process. Many proposals will change along the way. In the end, Congressional Republicans may not have the votes to pass their tax reform plan. However, it’s important for every American to pay attention to the debate. This has also prompted an important discussion about whether 401(k)s provide adequate retirement security and whether the current tax treatment of retirement savings is effective. There are proposals to change the retirement savings incentives in the tax code that would make them better suited to help working families save for retirement. Dramatically lowering the cap on 401(k) contributions to free up money is not good retirement policy. Polls show that the overwhelming majority of Americans want the federal government to pay more attention to the retirement security crisis. Voters must demand that their representatives have a full and thorough debate about retirement savings rather than make major changes simply to pay for massive tax cuts.