How a Lower 401(k) Cap Could Cause More Harm Than Good

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Wharton's Olivia Mitchell and J. Mark Iwry discuss possible changes to 401(k) plans as part of a tax overhaul.

The Republican tax overhaul is a plan in search of revenue – and one solution that appears to be under consideration for covering the proposed cuts is lowering the cap on pre-tax contributions to 401(k) retirement savings plans.

More than 62 million Americans have put money into 401(k) retirement plans, according to The Washington Post. Currently, those under age 50 can contribute up to $18,000 annually pretax, while older workers can contribute up to $6,000 more per year. Republicans are set to unveil their tax bill this week, and there is speculation that the legislation will include a reduction in the pretax contribution limit – which would boost government coffers by directing more money to post-tax individual retirement accounts, such as Roth IRAs.

While Republicans say the tax plan is designed to provide a boost for middle-class taxpayers, they have already come under fire for proposed changes to 401(k)s. The plans were initially introduced  in the 1980s as a supplement to traditional pensions, which guarantee a certain payout at retirement, but have now largely replaced them as the primary retirement benefit offered by employers. President Donald Trump took to Twitter say that his plan would not involve changes to tax-deferred retirement accounts after reports first surfaced that Republicans planned to sharply reduce how much Americans could save with them. He later said he might be willing to negotiate with Congress on such a move.

The Trump administration has to have some “pay-fors,” or revenue that would be used to offset moves like tax cuts and reducing the number of tax brackets – but a cap on 401(k) savings would be akin to kicking the can down the road, Wharton experts say. “The gem out there that many people are eager to get their hands on is the money that is currently not taxed,” said Olivia Mitchell, Wharton professor of business economics and public policy and director of the school’s Boettner Center for Pensions and Retirement Security.

However, individuals will have to pay taxes on their 401(k) and traditional-style IRA savings when they withdraw it, Mitchell noted. She added that Congress tends to look at the impact of tax proposals over a 10-year time frame, which would be a myopic view in this case. “To the extent that Congress is just looking at a 10-year window in doing its tallies on how much tax revenue will be brought in, they’re ignoring the fact that people would have paid taxes anyway on 401(k)s later, in their retirement,” she said. “So, it’s more a bring-forward; it’s a gimmick.”

Directing savings to Roth plans “by itself is not a bad thing,” said J. Mark Iwry, a visiting scholar at Wharton and a senior fellow at the Brookings Institution. But he frowned at the potential use of Roth plans to make it appear that the tax cuts would be paid for. “You are not really changing the economic flow of revenue gains to the government,” he said. “You are just taking them into account at an earlier time.” Iwry was formerly senior adviser to the Secretary of the Treasury and concurrently as the department’s deputy assistant secretary for retirement and health policy under the Obama administration.

“[A lower 401(k) cap] is more a bring-forward; it’s a gimmick.”–Olivia Mitchell

Mitchell and Iwry discussed the implications of a cap on 401(k) savings on the Knowledge@Wharton show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)

A ‘Roth-ification’ of Savings?

Mitchell says millennials are likely to increasingly put their money into Roth-type savings accounts no matter how 401(k) plans fare in Republicans’ pursuit of a tax overhaul. “My sense is that younger people who are in a low tax bracket, early in their life, like the Roth [idea],” she said. “They’ll put it in when they are in a low rate, and it will be non-taxable when they retire, when they may well be at a much higher [tax] rate.” However, people will gain no such advantage if they expect to continue to be in their current tax bracket when they withdraw the savings at retirement, she added.

However, few companies offer employees both the traditional 401(k) and Roth plans, partly because it gets confusing, Mitchell said. “People are not very financially literate … and they just want to be told [what to do] a lot of the time.”

According to Iwry, it’s advantageous to diversity your potential tax treatment “in much the same way that we typically would diversity our asset class investments.” It is analogous to modern portfolio theory, he noted. In addition to wanting to diversify the categories of risk in choosing investments, individuals could also decide that they may want some of their savings in Roth plans along with some traditional formats like a 401(k) plan or an individual retirement account (IRA), he said. “You are diversifying your exposure to the risk that tax rates could go up or down in the future.”

“It could easily work the other way” where people “stop saving altogether or save less.”–J. Mark Iwry

A Costly Gambit

The 401(k) plan is truly a tempting target for a government struggling to find new revenue sources. “A cap on traditional 401(k) contributions could substantially increase revenue during the normal 10-year budget window, between $500 billion and $1 trillion,” said Kent Smetters, Wharton professor of business economics and public policy. He is also faculty director of the Penn Wharton Budget Model, an interactive tool that allows analysis of budget proposals.

“Assuming that savers instead move to Roth accounts, most — but not all — of the revenue gain would be offset by losses outside of the 10-year window,” said Smetters. The losses outside of the 10-year window refer to the future loss in tax revenues since Roth savings will not be taxed at withdrawal.

Mitchell agreed that if more money goes into Roth-type retirement savings accounts, it would distort the fiscal deficit. “Because of the 10-year window, the Roth-ification of current contributions would lead to more [tax] revenue up front,” she said. “But what it doesn’t solve is the fact that we are going to have a deficit that is going to be exploding after that 10-year window. So, the potential for Roth-ifying all current 401(k) contributions can actually lead to less growth and less certainty because it just kicks the can down the road and we don’t really know the future of tax rates and the future tax regime.”

In the eventuality that a lower cap on 401(k) savings does not result in employees saving more in Roth-type plans, the implications for the economy as a whole could be worse. “To the extent that savers don’t use the Roth option and simply save less, national saving could be hurt,” said Smetters.

Brace for Reduced Savings?

Mitchell noted that some in the Trump administration expect people to save more through the Roth window, in line with the principles of behavioral economics. Under such a scenario, higher taxes would force people who plan to save a specific percentage of their earnings to consume less in the present and more in retirement. However, the possibility of that occurring is not backed by empirical research, she said. Only one study has looked at what happened to savings rates when companies adopted a Roth strategy for employee contributions, and it “didn’t find much difference,” she added.

Iwry added that it is not clear how a mandatory replacement of the tax-favored 401(k) part of employees’ retirement contributions with a Roth plan would work out. “It could easily work the other way” where people find the tax treatment options more confusing and decide to “stop saving altogether or save less.”

The average 401(k) savings in 2016 was about $6,000, which is well over the rumored cap of $2,400, said Mitchell. Such a change would affect 80% of all 401(k) savers, she noted. Indeed, the likely outcome of all those changes is that “people would probably end up saving less,” according to Mitchell. “They would tend to take a lower cap as ‘advice’ [from the government].”

Lower 401(k) contributions could also affect people who tend to use those accounts for borrowing. Employers commonly allow employees to take loans from their 401(k) plans, according to a 2014 research study Mitchell conducted in collaboration with the Vanguard Group. At any given time, about one fifth of all workers have taken a loan, and over a five-year period, as many as 40% take loans, she told Knowledge@Wharton in 2014.

“To the extent that savers don’t use the Roth option and simply save less, national saving could be hurt.”–Kent Smetters

Taming the Deficit

It is possible for tax reform to be revenue-neutral, said Iwry, and he pointed to proposals put forward by the Obama administration and others in Congress. He said that by tax reforms, he and Mitchell refer to a set of actions “that broadens the base, eliminates many or most of the special tax breaks and allows business and individual tax rates to be reduced, but maintains the progressivity of the system and is paid for.”

Mitchell agreed with Iwry. She said the proposed elimination of deductions for state and local taxes is expected to boost tax revenues by $1.3 trillion. “That is real money,” she said. “But the problem is the administration’s initial budget proposal would have added $1.5 trillion to the budget over the next 10 years. Currently, it is coming in at about $2.2 trillion more, so there really is an attempt to come up with [more] revenue.”

All said, if the federal deficit balloons, it could worsen the “continued and threatening insolvency of Social Security and Medicare,” said Mitchell. As those issues await solutions, “we’re just ending up with a greater uncertainty about future tax regimes,” she warned.

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