By Patricia Cohen - Oct. 28, 2017
When the benefits adviser Ted Benna first thought up a new type of employee savings plan in 1980, the client he created it for rejected the idea as too risky. After all, no one had previously used the unremarkable section of the tax code called 401(k) to defer paying taxes on money that rank-and-file workers set aside for retirement.
So Mr. Benna decided to try it out at his own workplace, Johnson Companies, a small consulting firm outside Philadelphia.
Without intending to, Mr. Benna set off a revolution. Nearly 40 years later, 401(k) accounts are the most common employer-sponsored retirement plans and a raft on which millions of Americans hope to float through retirement.
Suddenly, though, they are also at the center of a battle around the tax overhaul promised by President Trump and Republican leaders in Congress. A proposal to slash the amount of money workers can put in tax-deferred retirement accounts set off alarms among savers and members of the financial services industry, who contend that limiting the tax break would discourage contributions to 401(k) plans.
Many workers once could depend on defined-benefit pensions, but those plans — expensive for employers — have mostly gone the way of the Walkman. Instead, workers were left with the responsibility of saving for retirement themselves, with individual retirement accounts or 401(k)s. The switch has meant less security.
A retirement crisis already looms. Three out of four Americans worry that they will not have enough money to get through their retirements, according to the National Institute on Retirement Security. About 45 percent have not saved a cent toward it.
Mr. Trump, sensitive to the firestorm that could be provoked by limits on 401(k) contributions, tweeted that there would “be NO change” to this “great and popular middle class tax break” — before conceding it might be a part of legislative horse-trading.
Representative Kevin Brady of Texas, the principal Republican architect of the tax plan in the House, also scrambled to reassure critics that a rewrite would not undermine retirement savings.
“All the focus is on, can we help people save more,” he said.
Yet for all the alarming rhetoric about crushed nest eggs, there are a couple of things to keep in mind.
First, the debate on Capitol Hill is not really about retirement; it’s about lawmakers’ feverish hunt for revenue to finance tax cuts. Second, no matter what happens, it won’t solve the fundamental problem — that many Americans will outlive their savings.
There are several types of subsidized retirement accounts. People who work at larger companies tend to set aside money in a 401(k); they don’t pay taxes until they withdraw funds. By contrast, Americans who open an account known as a Roth get a different kind of break. They pay tax on money before it is deposited, but then get to withdraw it and the subsequent earnings tax-free in the future.
Details of the Republican tax plan have not yet been released, but the talk has been of imposing a cap of $2,400 a year on tax-deferred contributions to 401(k) plans — a sharp reduction from the current ceiling of $18,000 a year for people under 50, and $24,000 for people age 50 and above.
There would still be a tax benefit, but it would probably be under a Roth-style structure.
To some people, enjoying the break when they withdraw money instead of when they deposit it may not make a difference. But for Republicans in Washington desperately seeking a fast boost in revenue, timing is everything.
Their tax bill includes giant reductions in business taxes. Figuring out how to pay for tax cuts is always a grueling task, but it is especially complicated in today’s bitterly partisan atmosphere. Republican lawmakers intend to push through a bill without any Democratic support — but there is a catch. The single-party strategy in this case triggers a rule that requires the policy to have no impact on the budget at the end of 10 years. To make the math work, lawmakers need to come up with the revenue to pay for the cuts sooner rather than later.
That’s where 401(k)’s come in. Rather than allow workers to continue delaying their tax payments, the Republican leadership wants to collect tax revenue on most new contributions upfront so they can use it to pay for those expensive corporate tax cuts. That’s the equivalent of a middle-class tax increase.
“It’s just an enormous budget gimmick,” said William Gale of the nonpartisan Tax Policy Center. “It’s raiding future revenues to pay for current tax cuts. This is not a retirement security story.”
The accounting sleight-of-hand irks Mr. Gale, a former economic adviser to President George H.W. Bush, because, he says, it is financially irresponsible. “It’s just government borrowing by another name,” he said. “You’re not really raising revenue,” just changing when it’s collected.
The question of whether deferring taxes on retirement savings is actually good policy, however, is a separate matter.
Tax-subsidized retirement accounts have long roused fans and critics. Budget cutters point to the trillions of dollars they cost the Treasury Department. Groups concerned about growing inequality complainthat the tax break primarily benefits higher-income Americans who would save for retirement anyway. Those with more modest salaries generally have less access to work-based plans or can’t afford to save. Consumer advocates worry they are too vulnerable to the vagaries of the stock market.
Still, these retirement plans are extremely popular among middle and upper-income voters and many of the politicians who represent them — which is why previous attempts to eliminate them have failed.
Whether a tax-deferred 401(k) or a Roth is a better deal is not clear. Younger workers starting out can reasonably assume they are in a lower tax bracket now and benefit from a Roth, while middle-age workers may assume they will be in a lower bracket after they retire. But mostly there are question marks. Who knows if Congress will raise or lower tax rates 30 years from now, or if someone will shift from a higher tax bracket to a lower one? (It wouldn’t be the first time taxes on retirement income changed — Social Security benefits were shielded from federal income taxes for decades before the law changedin 1983.)
Mr. Gale says he thinks the immediacy of the 401(k) tax break encourages people to save more than they otherwise might. So does Mr. Benna, the 401(k)’s inventor. Although he says the tax deferral alone — without employers matching some of their employees’ contributions — was probably insufficient to persuade lower-wage workers to participate, it has nudged up middle-class savings. “It’s harder to save the same amount after taxes,” he said. “There will be a drop-off in contributions.”
But other experts aren’t so sure.
Andrew Biggs, formerly a principal deputy commissioner of the Social Security Administration, said that for most people, it makes little difference whether they pay taxes on retirement savings now or in the future. Automatic enrollment and the employer matches are much more important than the delayed taxes, said Mr. Biggs, now a retirement specialist at the conservative American Enterprise Institute.
Some studies have confirmed his hunch. One team of researchers looked at a handful of companies that offered a tax-deferred savings plan and then added a Roth option to the menu. They found the total amount of contributions didn’t change much. “The tax deduction was a pretty minor force,” said James Choi, a finance professor at the Yale School of Management and a part of that team.
And depending on future tax law, Mr. Choi said that retirees with Roth accounts could get by with smaller contributions than those with 401(k)’s because they won’t have to pay as much tax on the savings they withdraw.
The possibility that people may save less overall is fueling financial services industry opposition to the tax proposal currently in Congress. Plan administrators — which include major mutual fund companies like Fidelity Investments and Vanguard Group — are paid a share of the assets under their control; if the assets shrink, so do their fees.
What worries Mr. Choi, though, is the Republicans’ idea to cap the amount of tax-deferred contributions at $2,400 a year, while treating the rest like Roth contributions.
Setting the cap there could drag down savings because people tend to interpret such thresholds as recommendations, he said. From that perspective, it would be better to eliminate tax deferrals altogether rather than set such a low ceiling.
Yet whether the 401(k) caps are untouched, slashed or abandoned altogether, the prospect remains that millions of Americans will face retirement with no savings.
Follow Patricia Cohen on Twitter: @PatcohenNYT