Two high-profile economists recently caused controversy when they recommended that the IRS eliminate tax-deferred contributions to 401(k) accounts. Significant changes are unlikely to happen any time soon, and there’s no risk of your nest egg disappearing, so don’t panic about the headlines. However, it is important to understand the challenges and potential solutions currently facing policymakers when it comes to retirement planning. This will help you build a rock-solid retirement plan that can be successful regardless of future regulations.
Two economists have made a bold recommendation
The American Enterprise Institute (AEI) published an article in January in which two economists argued for eliminating tax breaks on 401(k) contributions. That proposal angered some — these are among the most popular retirement savings vehicles, and Americans have around $7 trillion saved in these accounts. The paper sparked a discourse about the problems at hand and the best ways to solve them.
It is not uncommon for economists at the AEI to advocate for deregulation or deficit reduction measures. However, this article caused a stir because it was co-authored by Alicia Munnell, a high-profile professor, along with Andrew Biggs, a senior fellow at AEI and former deputy commissioner of the Social Security Administration. Since the two have publicly disagreed in the past, this collaboration caused a stir.
The paper calls for a creative and drastic solution to the social security funding issue. The federal government’s guaranteed retirement income fund is cash flow negative, and the Social Security Trust is expected to be depleted by 2035. The gap arises from an imbalance between those paying into the system and those receiving benefits from the system. These problems are expected to stabilize in the late 2030s, but there is a serious threat to solvency in the meantime. At best, the liquidity buffer for future generations is exhausted and there is no margin of safety left. In all likelihood, there will need to be a combination of higher payroll tax rates and lower benefits to keep Social Security benefits secure.
Munnell and Biggs point out that 401(k) tax treatment costs the government nearly $200 billion in revenue annually. They suggest that these funds would be better served to support the Social Security system and increase the guaranteed income of future retirees.
The authors contend that 401(k) tax treatment did not have a significant impact on savings rates and that the tax incentives disproportionately help high-income people. They argue that tax policy has failed to achieve its intended goals and that regulators should address the widespread lack of retirement savings before there is a national crisis.
To be clear, this is not a suggestion to take away your existing 401(k) assets. If implemented, there will be no immediate tax charge or clawback of previous contributions. In fact, it is unlikely that this policy will even be approved. The authors probably know this, and the paper’s true intention may be to open new doors in public discourse about a serious, as yet unresolved problem.
Why this might be important
There won’t be any sweeping changes in the near future, but smart financial planners will recognize that some of the ideas are gaining traction. There is widespread agreement that future policy changes will be necessary, even if they are relatively modest. This paper serves as a warning about a possible solution that could be implemented in the next decade or two.
The conclusions and recommendations presented by Munnell and Biggs are quite radical and certainly met with resistance from other economists as well as legislators and public figures. There is strong opposition among economists to eliminating a popular tax benefit, limiting personal control over retirement savings and diverting additional funds into a social security system that many academics view as poorly managed.
What is noteworthy, however, is the non-partisan nature of the paper. Laws with broader support, particularly on such partisan issues as taxation and wealth redistribution, are more likely to be implemented. People on both sides of the aisle have reasons to support this, and that gives it support. If the legislation eventually passes, it could be influenced by some of the ideas proposed today.
What it means for your retirement planning
If you currently use a 401(k) account, keep doing so. Most financial planners support 401(k) contributions at least up to your employer’s maximum contribution amount, provided it doesn’t place an undue burden on your financial planning. Most people benefit from deferring taxation until retirement, when they are in a lower income bracket. If this benefit is at risk of being eliminated, it’s probably a good idea to take full advantage of it during the highest 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 amount you can deduct may be limited by your 401(k) contribution or income, but many households can still participate in these accounts.
The new proposals also serve as a reminder that you can save for retirement outside of tax-deferred accounts. Roth IRAs are great vehicles for growth investing because they eliminate any taxation on returns. You can also accumulate wealth by investing in brokerage accounts. These do not offer significant tax benefits, but they do provide liquidity and flexibility not available with other retirement accounts.
Finally, this is also a stark reminder of the threats to social security. Future generations will almost certainly receive Social Security benefits, but they may cover less of the average household budget than they do today. Being self-sufficient is always preferable, so you should aim to save at least 15% of your annual income. Dividing these savings across multiple investment accounts is a great way to give you options when you need to withdraw money to meet your cash needs.
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Should the government eliminate 401(k) accounts? “How to Prepare If These Economists Prevail” was originally published by The Motley Fool