Tax cuts often look like free lunches for taxpayers. Such is the case with the recent federal tax reform proposal. But tax cuts eventually have to be paid for with tax increases, closing of tax loopholes, or spending cuts, and that’s why average Americans need to pay attention to the unfolding debate on Capitol Hill.
The first red flag came several weeks ago when it was reported that House Republicans were thinking of drastically slashing the tax deduction for 401(k) contributions from the current annual $18,000 or $24,000 for workers over 50 to as little as $2,400, and mandating the use of after-tax Roth accounts for retirement savings.
Retirement income in the United States comes primarily from three sources: Social Security, pension plans sponsored by public and private employers and individual savings in taxable and tax-advantaged accounts. There are generally two types of employer-sponsored pension plans: defined benefits and defined contributions.
Back in the day, workers could depend on defined benefit pensions in which retirees received a predetermined monthly annuity, either for the rest of their lives or those of their spouses. The benefit amount was usually based on an employee’s wage, years of service and age at retirement. The employer was responsible for contributing assets sufficient to fund the promised benefits.
But employers claimed these plans left them overburdened by pension obligations and that defined contribution plans were much less expensive.
Now defined-contribution pensions are the most common employer-sponsored plans.
Around 54 million American workers participate in about 550,000 so-called 401(k) plans, named after the section of the tax code that created them in 1978. These plans hold more than $5 trillion in assets. Tax-deductible contributions to defined contribution plans are predetermined, but the amount of benefits received upon retirement is not guaranteed.
Workers pay taxes when they withdraw the funds, manage the money themselves and hope the market doesn’t crash just when they retire. While in a defined benefit plan the employer bore the risks associated with investing assets in the plans, the employee is responsible for bearing those risks un-der defined contribution.
When news filtered out that the deduction for 401(k) contributions might be slashed, retirement experts, Vanguard, Fidelity and other large mutual fund companies that manage assets in the lucrative 401(k) business joined together and howled like a pterodactyl. President Trump tweeted, “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!”
Fortunately, the long-awaited GOP tax plan unveiled last week leaves current contribution limits in place and abandons the notion that American workers are saving too much for retirement.
What were these Mighty Mendicants thinking? Cooking up a raiding party on workers’ 401(k) plans was a way to pay for the middle-class tax cuts lawmakers claim they want to provide. They also want to significantly cut corporate taxes to catch up with the rest of the world, which has already done so.
The proposal was pure budget chicanery. Capping what the average American can place in these pension plans would force workers to pay more in taxes now rather than when they make withdrawals from their pension account. In effect, the proposal would have helped pay for tax cuts by pulling future tax revenues forward.
Equally important, it would have undermined workers’ retirement security since the up-front deduction is an important incentive for workers to participate in retirement plans. Mil-lions of Americans depend on the favorable tax treatment of 401(k)s, IRAs and other savings vehicles to build long-term financial security.
The fate of House Republicans’ tax proposal is uncertain; the twists and turns ahead will surely provide first-rate entertainment. And taxpayers had best pay close attention to the tax legislation as it makes its way through Congress to ensure that the notion of capping 401(k) contributions is not resurrected as lawmakers scramble to find ways to pay for the tax cuts.