As tax reform moves front and center before Congress, details of the plan are beginning to emerge. One of the more controversial proposals that has gained attention recently is a modification to how most Americans currently save for retirement. This could have a significant impact for those of us who use 401(k)’s, 457(b)’s, 403(b)’s, 401(a)’s, and other similarly qualified, defined-contribution plans.
In order for tax reform to gain the support it needs from the Republican base, many congressmen are requiring that any changes not add to the deficit. In order to do that, they’re hoping a reduction in tax rates subsequently increases economic output. With a growing economy, the same dollar amount of taxes can be collected as before the reforms and the deficit stays the same. Others, however, want to see a more direct approach when it comes to offsetting some of the potential cuts. A target that has wandered into view for some of the Republican leadership is the tax-deferred contributions of retirement savings accounts.
As you may know, the tax code has previously established tax-deferred retirement accounts that encourage employees to save a portion of their earnings into an investable savings account (with restrictions) to be used for retirement. To incentivize this behavior, these contributions and the investment growth they experience are excluded from taxes. When the funds are later withdrawn in retirement, they are taxed like regular income.
Last weekend in an article on potential changes to 401k rules, the New York Times noted that in order to garner more favor for their tax plan, Republicans may try to reduce the contribution limits to 401k accounts and other accounts like them. Currently, the contribution limits are $18,000 per person per year but, given some proposals set forth, could be reduced to as low as $2,400. For many, simply saving at this lower annual limit would not be enough to provide for their retirement needs in addition to significantly increasing taxes for those who are currently taking full advantage of maxing out their retirement savings contributions.
It is easy to get frustrated when a significant benefit that many of us are utilizing gets targeted, but there a few things we should keep in mind in light of these potential changes. First, the final proposal has not come through and it is quite possible that this part of the plan will never come to fruition. Trump himself has come out against the part of the proposal which will add pressure to the author of the bills to leave it out.
Secondly, even as changes like this come forward, we still have the ability to react to whatever they may be. For example, while it sounds like the tax-deferred savings may be greatly reduced, there is little talk of reducing how much can be contributed to a Roth. It could be that we will be allowed to pay taxes now and then never pay taxes again which might already be the optimal path for many of those preparing for retirement. When looked at from that perspective, the plan appears to be short-sited with the government forcing us to pay taxes upfront but consequently forfeiting all future taxes on our investment earnings.
Another approach would be to save outside of an employer-established retirement savings account. While this option does not have the tax-saving elements of traditional retirement accounts, it may nevertheless be necessary in order to adequately prepare for retirement.
There are most likely going to be changes to the tax code that could impact the way we currently save. While that may be frustrating, it is important to remember that we can always react to what comes next and alter the way we approach saving and investing for retirement in an effort to be as efficient as possible however the new tax code may look like. As tax reform solidifies, Cedarstone will continue to stay on top of the changes and let you know what to expect and how best to prepare yourself.
Tankersley, Jim. “Republicans Consider Sharp Cut in 401(k) Contribution Limits.” The New York Times. Oct. 20, 2017. https://www.nytimes.com/2017/10/20/us/politics/republicans-tax-401-k.html.
[HB1]Front and center and focal point are the same thing