Potential Changes to 401(k) Plans and Their Impact on Employees
In the federal government’s eternal quest to raise tax revenue, corporate sponsored 401(k) plans are once again squarely in the crosshairs. At the moment, there are a number of proposed changes that could have a dramatic effect on how 401(k) plans operate.
The changes stem from how Congress views the tax breaks given to those who decide to save for retirement on a pre-tax basis through these types of savings vehicles. First of all, it’s important to understand that contributions to a typical 401(k) plan are tax deferred, not tax free — unless the contributions go into a Roth 401(k). That means the person contributing to the plan gets a break on paying taxes on that money today, but instead defers the taxes until later in life when the money is pulled out and put to use. This could be 10, 20 or 30 years down the road. So, the government does eventually get their tax revenue.
However, federal budget forecasts usually only take the next 10 years into account. As a result, 401(k) plans are unfairly placed into the same boat as the deduction for employer sponsored health plans. When the government looks at the nearly $5 trillion sitting in 401(k) plans, they salivate over the potential tax revenue. As a result, Congress has proposed a number of changes to how these plans operate. A few of these are listed below:
- Cap on Pre-Tax Contributions — Currently, an individual can contribute up to $18,000 to a 401(k) account pre-tax. This proposal would limit the pre-tax contributions to half of that amount ($9,000), and anything above would have to be characterized as a Roth 401(k) contribution.
- Limiting Tax Deferral to 28% of Income — Suppose an individual or family falls into a tax bracket higher than 28%, like 35%. They would only get a deduction on those contributions as if they were in the 28% bracket. As a result, they would have to pay tax on some of their 401(k) contributions. In addition, when they pull the money out at retirement, they would pay normal tax on ALL of the assets — effectively double taxing a portion of the retirement savings.
- Limiting Combined IRA/401(k) Balances to $3.4 Million — This is not really a limit on the account balance, per se, but a limit on how much annual income can be generated by these tax-deferred accounts. The current limit on income from a retirement vehicle is $210,000, which is generated by a present account value of roughly $3.4 million.
- Indexing of Plan Limits Suspended — Historically, 401(k) contribution limits have been indexed, meaning they can potentially increase a little each year. This proposal would suspend indexing and keep limits static for a 10-year period — effectively reducing the amount of income that could be deferred as a plan ages, and potentially increasing the amount of taxable income an employee takes home over that same timeframe.
It’s not certain which of these proposals, if any, will actually come to pass. And, while these proposals focus on limiting tax deductions, there are other proposals out there designed to increase coverage for those who don’t have access to an employer-sponsored retirement plan. We’ll continue to provide updates on all proposals and their potential impacts upon both plan sponsors and employees as the House and Senate advance in their debates.