By contributing to your traditional 401(K) plan, you can save on taxes today and invest in your retirement at the same time.
401(k) investors are waiting to see if a Republican-led tax reform plan will make changes to 401(k) investment plans’ tax-deductible contribution limits.(Photo: AndrewWilliam, Thinkstock)
401(k) investors could see the rules change for their retirement savings accounts when a Republican-led House committee rolls out its proposed tax overhaul plan.
The biggest potential change is slashing the maximum limit on pre-tax 401(k) contributions to $2,400 a year, down from the $18,000 IRS limit for Americans under 50 and $24,000 for Americans 50 or older in 2017. That would mean savers would be able to stash away fewer dollars in their accounts before income tax is calculated.
The proposed cut, which would dramatically reduce a key tax deduction for Americans, is viewed as a way for Republicans to boost revenue to help finance their tax cuts, which could increase the nation’s deficit by $1.5 trillion over the next decade.
While no specific details have yet to be released by the GOP, it is believed that any additional retirement savings amounts above the discussed pre-tax limit of $2,400 will fall under so-called “Roth” retirement savings taxation rules. Under Roth 401(k)s and Roth IRAs, payroll savings deductions come out of workers’ taxable income, while withdrawals of principal and market gains in retirement are tax-free.
If such a change in 401(k) rules were to be implemented, it could cause confusion, result in higher tax bills for workers, and could possibly result in people saving less — not more — at a time when Americans are already saving too little for their post-working years, 401(k) and tax experts say.
“Now is not the right time to impose a vast experiment on American workers and retirement savers,” says Derek Dorn, head of public policy at TIAA, a financial services firm.
The big risk is if savers view the gutting of the 401(k) tax break as a disincentive to save, says Garrett Oakley, a certified financial planner and CPA at Betterment, an online investment company based in New York.
“The lack of a tax-saving incentive will lead to less savings,” Oakley believes. “We know that any barrier put in place is going to lead to a lower savings rate.”
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The House Ways and Means Committee will unveil tax legislation soon, perhaps as early as Wednesday.
In response, Senate Democrats on Tuesday countered with a proposal that would allow all workers to save $24,500 in pre-tax dollars in 2018, which is higher than the IRS’s proposed $18,500 limit announced two weeks ago. The Democratic plan would allow workers 50 and older to save $30,500 pre-tax.
Since the GOP proposal would mark huge change, here are ways their proposal would impact 401(k) savers:
Less choice for savings options
Currently, most 401(k) plans give wage earners a choice between saving for retirement with pre-tax dollars — which lowers worker’s taxable income — or with post-tax dollars, as is the case with Roth-style plans.
Workers with sizable salaries that fall into higher tax brackets, for example, might prefer to save for retirement now with pre-tax dollars, while younger workers with modest salaries might be better off saving today with after-tax earnings with the hope of building wealth over time and paying zero taxes when they withdraw the money in retirement, Keenehan explains.
USA TODAY’s Charisse Jones offers tips on smart ways to utilize your 401(k).
Fewer tax benefits
“If Congress takes away (or substantially lowers) the tax deduction for contributing to a 401k plan, taxpayers who contribute to a plan will no longer get a tax deduction, which increases their taxable income,” says Mark Steber, Jackson Hewitt’s chief tax officer.
For someone who earns $75,000 a year in 2017 and contributes $18,000 a year to a 401(k), their taxable income would be $57,000, Steber explains. If the 401(k) contribution was capped at $2,400, that would make the same person’s taxable income $72,600, an increase of $15,600 in taxable income, a potential increase in federal taxes of approximately $3,900.
And with a smaller tax break, it will actually take more dollars to save the same amount of money, adds TIAA’s Dorn. For example, a $1,000 savings in a 401(k) that comes from pre-tax dollars will cost the saver $1,000. But with after-tax dollars for someone in the 25% tax bracket, it will actually cost $1,250 out of pocket once taxes are factored in.
A study by the non-partisan Employee Benefit Research Institute found that scores of Americans at all age brackets and income levels would lose a chunk of their up-front tax savings under the discussed GOP plan. Of those that earn between $10,000 and $24,999 per year, nearly four out of 10 (38%) now contribute more than $2,400 per year to their 401(k)s. And 87% of workers with salaries of $100,000 or more save more than $2,400 in their plans.
Could lead to less savings
If lawmakers lower the maximum deduction on 401(k)s to $2,400, there’s also a risk that savers will view the new lower amount as acceptable savings to set aside each year to secure a safe retirement. And that would be a huge financial mistake that could indirectly lead to less savings not more, says Anthony Nitti, tax partner at WithumSmith + Brown, a New York-based accounting firm.
What’s more, there’s a chance that employers will have to set up new plans to account for the new rules, which could result in savers opting out of the plan rather than staying invested, Nitti adds. “They might evaluate their situation and say, ‘I’d rather have the money now,'” says Nitti.
Bottom line: a big reduction in the amount of money that can be saved in a tax-favorable way will force people “to start saving for retirement in different ways,” says Andrea Coombes, a retirement specialist at personal finance site NerdWallet.
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