401(k) fears largely overblown regarding GOP tax plan

Congressional Republicans have been talking up changing the tax treatment of retirement savings. President Trump tweeted his opposition Monday. Is your 401(k) really at risk? Probably not, but all the misunderstanding shows how little attention our political process pays to a crucially important issue: how to save for retirement.

For months, there have been rumors that Republican tax reform plans could change the tax preference that Americans receive when they contribute to their 401(k) plans. Right now, most Americans contribute to an ordinary 401(k), which gives them a tax deduction in the year they make the contribution.

{mosads}Once they withdraw their funds in retirement, though, the 401(k) balances become taxable. Republicans have been talking of switching 401(k)s to so-called “Roth” treatment, in which contributions are taxable upfront but are tax free in retirement.

A more recent iteration would allow up to $2,400 in contributions with the upfront tax deduction, with anything over that getting Roth-style treatment.

What’s driving this change isn’t a concern about retirement saving or even about the size of tax preferences for retirement saving. It’s more about timing. Republicans want to cut corporate taxes, but need a way to offset the revenue losses.

Shifting 401(k)s to Roth treatment would shift future tax revenues to the present and therefore make the short-term budget impact of the tax bill smaller.

Call it a gimmick, but the point is that “Rothification” isn’t about retirement saving so much as it is greasing the budgetary wheels to make tax reform work. This happens with any major budget package, and it’s not surprising it’s happening here.

But will retirement savers fall victim to tax politics? The answer is probably not.

To begin, relatively few low- and middle-income Americans contribute more than $2,400 to their 401(k) each year. My read of IRS data is that about 50 percent of households would reach that limit, but most of that group is high-income.

Only 15 percent of households with adjusted gross incomes below $75,000 would face any limitation, versus 91 percent of households with incomes above $200,000.

Moreover, Rothification wouldn’t make much difference even to higher-income households. Sure, they’d lose the upfront tax deduction, but then their retirement withdrawals would be tax free. Some people do better with an ordinary 401(k), others with a Roth.

You can find calculators online which will help you decide which is best for you. But overall, the differences over your lifetime tend to be pretty small. If you’re doing other things right — participating in your employer’s 401(k), contributing enough to maximize the employer match and not doing anything crazy with your investments — then ordinary-vs-Roth isn’t going to matter much.

Cramer: Why sweeping tax reform will be hard to pass from CNBC.

In fact, total savings opportunities could increase. If a worker switched to Roth treatment continued to max out their 401(k) contribution, they’d pay taxes on that money in their tax return, but those taxes would be paid with money that’s not in their account.

An employee who maxes out their ordinary 401(k) wouldn’t pay taxes at the time, but then the account balance would be taxed on withdrawal. Assuming the same contribution rate, the retirement income produced by a Roth will be higher, by an amount roughly equal to the tax rate paid by the individual.

On Monday, President Trump tweeted, “There will be NO change to your 401(k). This has always been a great and popular middle class tax break that works, and it stays!” To be clear, there actually is a debate among economists regarding how well the 401(k) tax preference works at increasing saving.

For instance, if I save while working to hit some target rate of income in retirement — say, a replacement rate of 75 percent of my final salary — then a government subsidy may cause me to save less than I otherwise would because it costs me less to reach that target.

If that subsidy is effectively financed by government borrowing, then total national saving would fall, and the economy would suffer.

But that’s not the level of debate that U.S. retirement policy is operating at right now. On one side, we have Republicans who are planning a mostly harmless, but possibly beneficial change to 401(k) tax preferences, but for reasons that have nothing to do with retirement saving.

It’s probably this level of engagement that lead the White House to fear claims that tax reform would gut Americans’ 401(k)s and to run from the idea.

On the other side, we have Democrats who cry that there is a “retirement crisis” in which large numbers of households are undersaving for retirement by substantial amounts. In my opinion, the retirement crisis narrative is basically bunk.

Retirement savings are at record levels, having more than doubled as a percentage of personal incomes since 401(k)s were introduced in the early 1980s. Retirement plan participation rates and contribution rates have also never been higher.

Nevertheless, in politics perception is often reality. If Republicans act as if they’re not concerned about middle-class Americans’ retirement savings — or at least, are a lot less concerned about retirement saving than about tax cuts for corporations and very high earners — voters may opt for the other party’s options.

These include an expensive, across-the-board expansion to Social Security benefits and new retirement plans set up by state governments, which have poor records in managing their own pensions.

Tax policy is important, and so is tax policy toward retirement savings. But Americans, both in Congress and on Main Street, need a realistic and sensible conversation regarding what’s happening with retirement saving as a whole and what policies will help those who need it without overburdening the government or the economy.

So far we’re not getting that conversation.

Andrew G. Biggs is a resident scholar at the American Enterprise Institute.