While there is a laundry list of topics to discuss from President Trump’s vague tax reform initiative, I’m going to focus on how various rumblings about the tax plan on 401(k) plans could affect not only those employer plans, but what could possibly develop into a great shift of assets out of 401(k) plans and into other retirement vehicles.
First, know that Trump stated that there will be no change to the way 401(k) plans are run, and the tax advantages inherent with said plans.
Yes, it’s 2017 and we get our tax plan details via Twitter.
However, there have been rumors from Republicans that to pay for the tax cuts they propose, they will limit most of the deductions Americans use today to lower their taxable income. One of the ways representatives are ideating to make up for the proposed tax cuts would be to lower the limits on deductibility of 401(k) contributions.
One proposal calls for lowering the deduction limits in such plans from $18,500 in 2018 to only $2,400 annually. This is a significant decrease and if it moves forward, could forever change the approach many businesses take in designing an employer-sponsored retirement plan.
While they plan to lower limits inside 401(k) plans, they intend to increase limits for after-tax contributions in Roth IRAs and therefore, would probably do the same for Roth 401(k) contributions. Clearly motivating Americans to pay the taxes now so they can pay for their tax plan, rather than incentivize savers to defer paying taxes until retirement.
These changes will motivate employers to adopt Roth 401(k) options, switch to SIMPLE IRA plans (that have very specific limitations in plan access and contribution limits) or simply get rid of these plans altogether. If employers continue to reap the benefits of tax deductions for Roth 401(k)s, just as they do for traditional and Roth 401(k) plans currently, then we may see things continue as is.
However, if the government eliminates those tax benefits for employers to pay for the tax cuts we will see the demise of the majority of 401(k) plans. This reduces tax benefits for both employers and plan participants. In such a scenario, we would see a great transfer of assets from 401(k) plans to Roth IRAs from both employers and employees. A great opportunity for advisors- with many setbacks for investors.
First, savers will be able to access ALL of their principle within a Roth IRA. Currently, 401(k) plans limit borrowing to 50% of the account balance or $50,000. I don’t see this as a benefit to Roth IRA owners. If anything, it will allow for more opportunity for account depletion by gaining access to a much larger pile of retirement money that was previously inaccessible.
Second, in reducing the matching component of a traditional or Roth 401(k) plan, I see a reduction in the number of Americans who save for retirement. We all know Americans don’t save enough for retirement now, imagine how many fewer would without the monetary incentive to receive “free money” from employer matching contributions.
Lastly, the effect on the small business owner needs to be discussed. Yes, Trump plans to lower corporate taxes for C-Corps to 20% and down to 25% for other small business entities. However, losing the ability to max out their 401(k) accounts with both their contributions as an employee and matching from the business ($53,000 in 2017) would be detrimental to middle class small business owners. Many are used to deferring tens of thousands of 401(k) contributions each year, so limiting this to $2,400 would certainly deter small business owners from establishing or maintaining a costly 401(k) plan.
Don’t get me wrong, I LOVE a Roth IRA and Roth 401(k) for younger investors. And millennials tend to better savers then past generations, as we watched first hand as the previous generations struggled through the Great Recession and are currently weathering life with what seems to be insurmountable student loan debt. However, the change proposed by the government will truly only benefit that generation. Older investors moving to a Roth vehicle, especially those planning to receive less taxable income in retirement compared their current employment income, are left out to dry.
Now, the government could allow business owners to continue to make non-elective deferrals through Roth 401(k) plans, but based on the way things are looking to be structured, I highly doubt that benefit would remain as Trump’s plan calls for taxation now to pay for the cuts rather than incentivizing savers to defer taxes until they withdraw assets in retirement.