Two prominent economists recently caused controversy by recommending that the IRS eliminate tax-deferred contributions to 401(k) accounts. There's no need to panic about the headlines, as big changes are unlikely to happen anytime soon and your nest egg isn't in danger of disappearing. Still, it is important to understand the challenges and potential solutions that policymakers currently face related to retirement planning. That way, you can build a solid retirement plan that can succeed regardless of future regulations.
Two economists made a bold proposal.
In January, the American Enterprise Institute (AEI) published an article in which two economists argued for eliminating tax breaks for 401(k) contributions. This suggestion confused some people. They're one of the most popular retirement savings tools, with Americans stuffing about $7 trillion into these accounts. This paper sparked a debate about the problems at hand and the best ways to solve them.
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It's not uncommon for AEI economists to argue in favor of deregulation and deficit reduction measures. But the article caught some people's attention because it was co-authored by distinguished professor Alicia Munnell and Andrew Biggs, a senior research fellow at AEI and former deputy commissioner of the Social Security Administration. The two have publicly disagreed in the past, and this collaboration has attracted attention.
This paper calls for creative and radical solutions to the Social Security funding problem. The federally guaranteed retirement income fund has negative cash flow, and the Social Security trust is projected to be depleted by 2035. This shortfall is caused by an imbalance between those who pay into the system and those who benefit from it. These problems are expected to stabilize in the late 2030s, but in the meantime there remain serious threats to solvency. At best, the cache buffer will be exhausted for future generations and there will be no safety margin. Perhaps some combination of payroll tax rate increases and benefit cuts will be needed to keep Social Security benefits safe.
Munnell and Biggs point out that 401(k) tax treatment costs the government nearly $200 billion in annual revenue. They suggest that these funds are suitable for supporting the Social Security system and increasing the guaranteed income received by future retirees.
The authors argue that 401(k) tax treatment does not have a significant impact on savings rates and that tax benefits disproportionately support high-income earners. They say the tax policy has failed to achieve its intended goals and that regulators should pivot to addressing widespread retirement savings shortfalls before they become a national crisis. .
To be clear, this is not a proposal to take away your existing 401(k) assets. Once it goes into effect, there will be no immediate tax charge or recovery of previous contributions. In fact, this policy has no chance of being approved at all. The authors probably know this, and the paper's true intention may be to open new doors to public debate about serious unresolved issues.
why is this important
Big changes won't happen right away, but smart financial planners will notice some ideas that are gaining traction. It is widely accepted that future policy changes are needed, even if the changes are relatively gradual. This document serves as a warning about one potential solution that may be implemented within the next 10-20 years.
The conclusions and recommendations presented by Munnell and Biggs were somewhat radical and certainly provoked a backlash from fellow economists as well as members of Congress and celebrities. Eliminating popular tax incentives among economists, limiting individual control over retirement savings, and directing additional funds to a Social Security system that many academics consider poorly run. There is a lot of resistance to this.
But the paper's bipartisan nature is notable. Legislation with broader support is more likely to be enacted, especially on partisan issues such as taxation and wealth redistribution. People on both sides of the aisle have reasons to support this, and that gives them some foothold. When the bill is ultimately passed, it may be influenced by some of the ideas currently being proposed.
What it means for retirement plans
If you currently have a 401(k), keep using it. Most financial planners will support 401(k) contributions up to a maximum amount that at least matches the contribution provided by your employer, as long as it does not overburden your financial plan. Most people benefit from delaying taxation until retirement when they are in the lower brackets. If there is a risk that the benefit will be discontinued, it would be wise to make the most of it during peak income periods.
Earners in higher tax brackets should also consider contributing to a traditional IRA, which is treated the same as a traditional 401(k). Deductions may be limited by her 401(k) participation or income, but many households can still participate in these accounts.
The new proposal also serves as a reminder that you can save for retirement outside of tax-deferred accounts. Roth IRAs are a great vehicle for growth investing because they eliminate taxes on earnings. You can also accumulate wealth by investing in a brokerage account. Although they do not offer meaningful tax benefits, they do offer liquidity and flexibility not available with other retirement accounts.
Finally, it is also a stark reminder of the threat to Social Security. Future generations will almost certainly receive Social Security benefits, but they may cover less of the average household budget than they do today. Being self-sufficient is always preferable, so you should try to save at least 15% of your annual income. Spreading these savings across multiple investment accounts is a great way to provide options when you need to withdraw funds to meet your cash needs.
