Since the early 1980s, 401ks have steadily become a primary means of retirement income for many Americans. For the most part, 401ks have replaced defined benefits plans, which were predominately pension plans. A 401k is considered a defined contribution plan, which translates to employee and employer contributions versus a defined benefit plan (pension), in which the employer was the sole contributor. Employers, though, are under no obligation to make any contributions.
Today, there is talk coming from Washington D.C. about sweeping tax reform. Many people have heard about the proposed decrease in corporate and personal tax rates and a simplified filing process. But potential changes to 401ks have not received as much attention. During a recent meeting of the National Association of Plan Advisors (NAPA) with congressman Kevin Brady, Chairman of the United States Committee on Ways and Means, 401k reform was discussed. One of the changes to 401ks that is under consideration is lowering the deductibility, or pre-tax amount.
To help understand why reducing the amount that can be saved is on the table, it’s good to take a historical perspective. In 1986, under the Tax Reform Act, President Ronald Reagan signed into law the reduction of the amounts that can be saved in a 401k plan from $30,000 to $7,000. At that time, the individual federal rate could be as high as 50 percent, with the corporate rate at 46 percent, before accounting for state and other income tax rates. For example, New York had a tax rate as high as 70 percent in 1986. And, in the 1980s, fewer Americans had 401k plans. Thus, lowering the 401k contribution amount to receive a reduction on income taxes was an easy compromise. Today the 401k plan is now a primary and sole savings vehicle for many Americans, so changing the amount without significant tax reductions will not be an easy battle for lawmakers.
Based on the recent meeting with Chairman Brady, the limits of tax-deferred amounts may decrease back to $7,000 (from $18,000 currently) with the balance of contributions diverting to a Roth IRA allocation. Combining the 401k with a Roth IRA will keep the total contribution limits the same, $18,000 for those under 50 years old and $24,000 for those over 50. Remember, contributions made to a Roth IRA are taxed, but any growth in investments is not taxed, provided certain conditions are met. This may not be a bad compromise as Roth IRA money will still accumulate tax-free. Having a pool of money to withdraw from at retirement with less to pay on taxes may be a beneficial strategy for many. At that same meeting, it seemed both sides of the partisan divide agreed that Roth IRA provisions would stay the same. This may be good as the benefits of a Roth IRA are often overlooked. There is a long way to go before any changes are made to 401ks or tax reform in general. However, it is always prudent to have a good understanding of how upcoming changes may impact retirement.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. This information is not intended as authoritative guidance or tax or legal advice. You should consult your attorney or tax advisor for guidance on your specific situation.
401k withdrawals taken prior to age 59 ½ may be subject to 10% penalty tax, in addition to ordinary income tax.
Roth IRA withdrawals may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Global Retirement Partners (GRP), a registered investment advisor. GRP, StoneStreet Advisor Group, NAPA Government Affairs Committee and LPL Financial are separate non-affiliated entities.