PMC Weekly Review - October 27, 2017

A Macro View: The 401k Deduction—A Taxing Conundrum

The subject of taxes has dominated policy news as Republicans work on an ambitious overhaul of the US tax system. Lawmakers are looking to cut taxes paid by businesses and individuals by an estimated $1.5 trillion over the next decade. To help pay for the potential cuts, some Republicans have proposed a reduction in the amount Americans can contribute on a pre-tax basis to their 401(k) retirement plans. Currently, employees are allowed to contribute up to $18,000 per year ($24,000 for those over age 50) to their retirement accounts. There have been reports that proposed changes could lower this amount to $2,400. Although President Trump tweeted that the tax plan will not include changes to the 401(k) plan, Republican leadership has indicated this change may still be on the table. Since its creation in 1978, the 401(k) plan has been an immensely popular vehicle for Americans to save for retirement, as pensions have fallen largely by the wayside. Because of this popularity, any changes are likely to be politically challenging, but if enacted, what impact could these proposed changes have on participants in these plans?

At first glance, a change in contribution limits would seem to be a disadvantage for plan participants. By limiting the deductibility of contributions, employees will likely have less incentive to contribute to workplace savings plans, potentially decreasing the amount Americans save for retirement. Given the current state of American’s inadequate retirement savings, this certainly seems detrimental. However, employees will still have the option of contributing to plans on an after-tax basis. With this option, participants pay taxes on their contributions in the year in which they contribute. The earnings will grow tax-deferred, and participants can withdraw the money tax-free once they reach retirement age.

The traditional rule of thumb has been that participants expecting to pay a higher tax rate during retirement than in their working years are better off paying the taxes now and enjoying tax-free withdrawals in their retirement years. However, most Americans expect to earn less income in their retirement years, which assumes a lower tax rate then. In this scenario, a participant is better off contributing on a pre-tax basis and paying taxes (at a lower rate) on withdrawals during retirement. Given these assumptions, it would seem that drastically reducing the deductibility of contributions could be disastrous for savers.

However, this might not be the case for most Americans. Recently, John Beshears, a behavioral economist at Harvard Business School, conducted a study1 in which he looked at long-term retirement outcomes for participants of both pre-tax traditional 401(k)s and after-tax Roth 401(k)s. His results concluded that using this traditional rule of thumb didn’t lead to better outcomes for most participants. Rather, participants in Roth 401(k)s consistently ended up with more spending power in retirement than those with a traditional 401(k), regardless of tax rates during working years and retirement. The reason for this comes down to human behavior. Most plan participants use rules to determine their contribution amounts, and these rules are similar, regardless of contributions’ deductibility. As a result, participants contribute the same amount to after-tax plans as they would to pre-tax plans, thereby nullifying the advantage of pre-tax plans. If participants don’t take advantage of the tax incentive to contribute more, account balances will end up being the same amount at retirement, whether they are in pre-tax or after-tax vehicles. With account balances being equal, the after-tax account will provide greater spending power due to tax-free withdrawals.

The bipartisan popularity of the traditional 401(k) plan certainly makes any proposed changes a political unknown, especially if the taxes slashed by these savings are seen to benefit disproportionately the very wealthy. Coupled with President Trump’s opposition to these changes, it is difficult to predict the likelihood of any proposals ultimately becoming law. The actual impact for Americans is also difficult to assess. At first pass, basic math would indicate many Americans would be worse off in retirement. However, human behavior doesn’t always follow mathematical principles, and there is at least some evidence many Americans would be better off by contributing after-tax dollars to their retirement plan. 

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1 Harvard Business School

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