401(k) Plans Teeter on the Fiscal Cliff
Among the many tax “loopholes” on the chopping block in the fiscal cliff negotiations are the 401(k) contribution limits. Liberals like to refer to tax deductions, deferrals, and exemptions as “spending through the tax code,” or “tax expenditures.” Of course, there are certain tax subsidies and credits that might best be described as spending (e.g., subsidized coverage on the Obamacare exchanges).
But conservatives and libertarians recognize that private property rights are at the foundation of individual liberty, and that any just government must be dedicated to protecting the individual’s right to the fruits of his labor. Treating a legitimate tax deduction as government spending presumes that the government has a right to those fruits by default - that we are privileged to retain any such fruits, and the government spends its funds in permitting it. This confiscatory mindset is foreign to our founding and inconsistent with our nature.
The proposed changes to 401(k) contribution limits are a good example of the threats to economic liberty we face as the revenue hawks continue to scour the tax code for backhanded tax increases.
What is a 401(k) Plan?
The traditional 401(k) plan is a method of tax deferral. You contribute with pre-tax dollars, the account grows tax-free, and you pay ordinary income tax on the distributions when you retire. If your employer offers a Roth option, you can contribute with after-tax dollars, and both the gains and distributions will be tax-free. In 2012, employees can elect to contribute up to $17,000, and the total employer/employee combined contribution limit is $50,000.
What’s Being Proposed?
The Bowles-Simpson proposal to reduce the total contribution limit to the lower of $20,000 or 20% of income. This is generally referred to in the pension industry as the “20/20 cap.” It is rumored that the employee contribution limit would be reduced to $14,000.
Why Is the 20/20 Cap Being Proposed?
Revenue. Bowles-Simpson intended to reduce rates and simplify the code. Under that proposal, you could argue the 20/20 cap made sense. Now we’re talking about raising rates and adding more complexity to the code on top of eliminating so-called loopholes.
Also, scoring. CBO scores bills based on they affect spending or revenues for up to ten years out. Most 401(k) contributions do not result in taxable income (i.e., are not withdrawn) until more than ten years after the contributions are made. Therefore, although 401(k) plan contributions are a tax deferral, it’s my understanding that they are generally scored by CBO as an exclusion. Add this to the list of the list of too many issues with CBO’s scoring methods.
What’s Not Being Proposed?
There is no proposal for the federal government to seize and nationalize existing 401(k) and IRA accounts to fund Social Security or any other governmental annuity program. That isn’t to say that liberals wouldn’t like to. In light of the fact that 401(k) limits are on the table in the fiscal cliff negotiations, Mark Levin recently replayed his scathing interview of law professor Teresa Ghilarducci who testified in front of Congress promoting this fantasy. However, I’ve never seen any evidence that this has ever been seriously considered, and I would be shocked if it ever is. There may come a time where private pension plans are eliminated going forward, but I refuse to believe that existing accounts would be confiscated.
In other words, worrying about the federal government seizing your private pension anytime soon is about as rational as Obama worrying that Boehner will successfully negotiate a flat tax. The much more likely result is that employers simply stop offering a 401(k) plan if limits are lowered because the cost to maintain the plan will outweigh the tax advantages.
Why Can’t I Just Contribute to an IRA?
You can, but the main downside is that the IRA contribution limit is only $5,000 (in 2012). You also don’t receive the same creditor and fiduciary protections of ERISA. The automatic payroll deduction makes it easier for many to save through a 401(k), too.
Why Don’t Democrats Support 401(k) Plans?
To be fair, a lot of people on all sides don’t support 401(k) plans. They have a terrible reputation, particularly when the market tanks. The liberal viewpoint, though, is that these plans disproportionately benefit the rich because high earners can afford to contribute at or near the limits. This theory disregards the strict nondiscrimination requirements that apply to 401(k) plans. It also fails to recognize how insignificant these amounts are compared to the far larger tax deferrals made by executives and other high earners under nonqualified deferred compensation plans.
More importantly, there have been a number of industry studies showing how 401(k) plans provide crucial retirement savings benefits to lower and middle income families. For example, a recent release by the American Benefits Council on the 20/20 cap proposal states that close to three-fourths of all 401(k) plan participants are in families with incomes under $100,000 (an income level that even President Obama has not referred to yet as the millionaire rich), and that those families receive 62% of the tax benefits associated with the plans. A separate release by the Employee Benefits Research Institute on the 20/20 cap found that although the proposal would reduce the tax benefit to the greatest degree for the highest income quartile, the lowest income quartile would experience the second highest average percentage reductions. Furthermore, younger workers will face greater average reductions because they will face reduced limits for a greater number of their earning years.
Why You Should Support 401(k) Plans
There is quite a bit of nostalgia these days for the annuity-type of pension your grandpa had, referred to as a defined benefit plan. Here are three reasons that your 401(k) plan is better, not just for your employer who avoids the tremendous and unpredictable liabilities intrinsic to a defined benefit plan, but also for you.
1) You Control It
With the 401(k), you have an individual account, and you choose how much to contribute and the investments. You have the flexibility to take as much or as little risk as you want, and when you retire, you can withdraw as much as you want whenever you want.
With the defined benefit plan, there’s top-down control of every aspect. The contributions, investments, and withdrawals are all generally out of your hands. The funds are pooled into a pot controlled by investment professionals. They can use the size of the pot to invest in vehicles generally unavailable to the individual investor, but you have no control.
People change jobs frequently in the modern economy. Unfortunately, most defined benefit plan benefits do not vest until you’ve stayed on the job for five years. That means you get nothing unless you stay five years.
Contrast that with the 401(k) plan. Every cent you contribute is immediately fully vested. You earned that money, you elected to defer it, it’s yours. Employer matching or profit sharing contributions may not be immediately vested, but you won’t lose any of your deferrals, even if you leave every job after six months. And when you do leave the job, you can keep the 401(k) plan with the previous employer or directly rollover the account to an IRA of your choice that preserves all the same tax advantages.
3) Defined Benefit Plans are not Guaranteed
Defined benefit plans are often advertised as providing a set payment stream that the employee can rely on. But what happens if your employer goes bankrupt and ceases to exist? Defined benefit plans pay premiums to the Pension Benefit Guaranty Corporation to insure against this situation. However, there is no guarantee that this will protect your entire benefit - the coverage is subject to certain limits. In other words, your retirement security depends on your employer’s continuing solvency.
What happens to your 401(k) when the company goes under? Virtually nothing. Every cent contributed is guaranteed in a trust with a specifically designated account to protect your interest.
According to the American Society of Pension Professionals and Actuaries’ new lobbying effort to prevent the 20/20 cap, 83% of Americans oppose reducing 401(k) contribution limits. This number does not surprise me. 401(k) plans are the consummate expression of American individualism, empowering employees to control the timing, taxation, and investment of their compensation in a manner that promotes flexibility and personal responsibility in retirement planning over centralized control.
In an ideal world, a low flat tax or the FairTax would not require any tax-advantaged structure for individuals to save for retirement. But reducing or eliminating the tax preferences to save for retirement under our current tax code could seriously jeopardize the ability of millions of workers to adequately save for and control their own retirement through a 401(k) plan. Let’s hope that the 401(k) limits, along with many other important tax preferences under threat, survive Boehner’s inevitable blunder.