The Trump administration has been clear in stating its objective to reduce individual and corporate tax rates. But to fund the reduction in tax revenue, one of the items they are looking at changing is the deductibility of employee 401(k) deferrals. The Joint Committee on Taxation, which acts as an advisor to Congress with research on the tax code, has shown that tax-preferred treatment of defined contribution plans will cost 583.6 billion in foregone revenue between 2016 and 2020. This could be very tempting for congress as it looks at ways to fund the tax cuts. Choosing to change the 401(k) tax rules by doing away with the tax deferral benefits of employee 401(k) contributions would be shortsighted and very harmful to the retirement system in the US.
As a refresher for those of you that don’t stay on top of the tax laws, here is the way the tax laws work with contributions to and distributions from 401(k) plans today.
- When an employee contributes to their company’s 401(k) plan, the employer deducts the contribution from the employee’s gross pay before income taxes.
- The contribution goes into the retirement plan without having been taxed (except for FICA).
- When you retire and start withdrawing funds, the entire amount is taxed, both what you and your employer contributed as well as any earnings you made on the investments.
The change that is being considered would make 401(k) plans more like Roth plans. In a Roth plan, your contributions are made with money that has been taxed, but when you withdraw it, then the full withdrawal is tax-free both contributions and earnings.
Many 401(k) plans offer a Roth option today where you can contribute after-tax earnings in return for tax-free distributions when you retire. What is being considered by the current administration, however, would be to do away with tax deferred 401(k) contributions and make all contributions after tax, like Roth plans. Personally, I like having the option of either making tax-deferred contributions or making after-tax contributions.
401(k) Tax Rules Changing?
When Congress starts messing around with mine and your retirement plans, I get nervous, as I am sure you do, too. When you start changing the rules in the middle of the game, it makes you wonder if they may change the rules again, somewhere out in the future. I have some funds invested in a Roth plan, but most of my 401(k) money is in the traditional tax-deferred plan. I would rather take the present benefit of investing pre-tax dollars and then pay the income tax on withdrawals when I retire at what should be a lower tax rate.
One reason I have been hesitant to invest more in the Roth option is a nagging fear that when I start withdrawing the tax-free Roth funds in retirement, that the rules may change ─ making the withdrawals taxable, or at a minimum, taxing the earnings.
I think you would see a reduction in employee contributions to their 401(k) plan if employees must invest with after-tax dollars. Contributions rates are already lower than they should be for most individuals to properly fund their retirement, let’s not worsen the situation.
What Happens to the Government’s Revenue Stream?
The other aspect of this potential change the administration should consider is that one day those Roth funds will be withdrawn as tax-free dollars.
Distributions from 401(k) plans are already generating tax revenue for the government as participants are retiring and making voluntary withdrawals or taking out the required minimum distributions required by law once you reach age 70 and a half. This revenue stream is going to continue increasing as baby boomers retire and the generations that follow that have no pensions will rely heavily on their 401(k) plans to fund their retirement.
With a drastic shift to Roth type plans, that increasing revenue stream will start decreasing when the Roth withdrawals start kicking in. With the 20 trillion plus in debt this country has incurred, don’t think those future tax-free Roth distributions will last long before the government decides to tax them to help pay for this country’s interest and debt retirement obligations. And don’t think that the average American won’t come to that same conclusion if the government promises future tax-free retirement income in exchange for taxing your contributions today.
President Trump, changing the tax laws as it relates to our retirement plans is a bad idea. Very bad. Stupid.
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L. Burton Keller was a principal founder of the company in 1985 and currently focuses on strategic initiatives for the company. Mr. Keller is a former member of the Bank, Trust and Retirement Advisory Committee of the Investment Company Institute. He has served on numerous committees and task force groups with the ICI over the last 17 years including Co-chair of the Dividend Distribution Task Force.