It’s Hard to Know If The Proposed 401(k) Tax Rule Will Hurt or Benefit Savers

One of President Trump’s big campaign promises was tax reform, but he’s not the only politician to dangle this carrot in recent years. Obama and the second Bush also promised to simplify the U.S. tax code, yet both left office without enacting the big reforms many hoped for.

Trump’s plan is still taking shape, but one of the ideas floating around is eliminating the 401(k) tax benefit to offset a decrease in tax rates. Many pundits have come out against this idea, arguing that it will hurt the middle class’s ability to save for retirement. But whether that’s true depends on future tax policy.

Under current law, any money placed into a 401(k) account is not taxed at the time it’s earned. The money can sit in the account and earn interest until retirement, and no income taxes are paid on the original money or earned interest until the money is withdrawn. The plan currently being considered would tax the money before it’s saved, but future withdrawals would be tax free. Many 401(k) plans already offer such a product, called a Roth 401(k), that’s named after the similar Roth IRA that also taxes contributions but not withdrawals.

Whether a traditional 401(k) or Roth 401(k) is better for middle-class savers depends on whether tax rates are going to be higher or lower in the future. Picture a young person starting out and making, say, $30,000 annually but who expects to earn more money down the road and have a well-funded retirement. It may be better to pay taxes on what she saves today, rather than in the future. If her retirement income ends up being $80,000 annually, she will be in a higher tax bracket than she is now, which means she can minimize her tax burden by paying taxes up front in her low-earning years.

Alternatively, a person in her peak earning years making, say, $150,000 per year but who expects to earn $80,000 when she retires would want to invest in a traditional 401(k) that waives taxes up front.

Expected earnings are not the only thing to consider when thinking about retirement contributions. If a person expects tax rates to go up in the future regardless of their own earnings, perhaps to cover the country’s growing national debt or to fund healthcare for an aging population, it may also make sense to contribute to a Roth 401(k) and pay taxes today rather than in the future when rates are higher.

For the nation as a whole, functionally replacing 401(k) tax benefits with Roth 401(k) benefits in order to offset tax rate cuts is largely a budgeting gimmick. The tax revenue the government gets today will be offset by the tax revenue it doesn’t get tomorrow when everyone is contributing to a Roth 401(k) and withdrawals are untaxed. But this type of kicking-the-can down-the-road strategy is typical of Congress, regardless of the party in charge.

Of course, another worry is that Congress will eliminate the traditional tax benefit today and a future Congress will also eliminate the Roth benefit. No Congress is bound by the laws of its predecessors, and if money gets tight it wouldn’t be surprising if a future Congress wanted to tax some retirement withdrawals after contributions had already been taxed. As the saying goes, a tax benefit in the hand may be worth two in the bush.

All that said, it’s difficult to know whether we will be worse off on average if Congress eliminates the current 401(k) tax benefit, since any cost-benefit analysis depends on largely unknown future tax rates. Moreover, this is just a small part of a broader plan we haven’t seen yet, and so it’s best to withhold judgement until we can make a fair comparison between a final plan and current tax policy.

Hopefully, any final plan contains more than just slight modifications to the status quo, since this country’s tax code is a mess. A recent study finds that compliance costs for the income tax alone are approximately $200 billion per year, or 1.2% of U.S. GDP. Most people aren’t opposed to paying some taxes, but none of us want to spend hundreds of dollars and precious hours doing so. It will take more than a tweak to 401(k) rules to provide badly needed compliance relief.


Adam Millsap is the Assistant Director of the L. Charles Hilton Jr. Center for the Study of Economic Prosperity and Individual Opportunity.

 

 

 

Feature photo obtained from MichaelPlaks.com.

 

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