The Next Big Threat to Your 401(k): A Tax Break Shake Up

It's bad enough the stock market has been beating up on most of our 401(k)s lately. Now, legislators and big thinkers are debating a variety of proposals to reduce the tax benefits of saving in 401(k)-type plans.

One idea being floated would take away the immediate tax deduction you get for your contributions. So if you make $50,000 a year and contribute $5,000 to your 401(k), you'd no longer have the pleasure of seeing your taxable income drop to $45,000.

Right now, Americans are typically taxed once on dedicated retirement accounts: Either you contribute pretax income and don't pay taxes until you take the cash out -- as with your 401(k), for example -- or you pay in with your post-tax income, but the money that you withdraw at retirement is tax free -- as with a Roth IRA. Under this new scenario, those 401(k) investments could be taxed both before and after taxes, just like your regular investments.

But some things may be sacred. There's not a high probability that you'll have to pay taxes on your profits any sooner than you do right now. Say you have $100,000 in your 401(k) and you make $5,000 in capital gains on it. As it stands now, you wouldn't get taxed on that $5,000 until you withdraw it, and there's not much chatter that anybody is looking to change that.

So who has the most to lose from the proposals being debated? Low-income workers, says the nonpartisan, nonprofit Employee Benefit Research Institute, because they're the ones most likely to respond to a loss of the tax break by either cutting their contributions or stopping them altogether.

A Major Disincentive to Save for Retirement

At a recent hearing of the Senate Finance Committee, EBRI Research Director Jack VanDerhei, explained the potential impact.

"As expected, the highest-income workers generally would be the most affected if federal tax limits in 401(k) type plans were lowered," VanDerhei said in a prepared statement. "But the surprising result we found is that the lowest-income workers would also be very negatively affected, and many report that they would reduce contributions or stop saving in their work-based retirement plan entirely, if the current exclusion of worker contributions for retirement savings plans were ended."

For instance, VanDerhei said that if workers lost their deduction in 2012 and saw it replaced with flat-rate tax credits -- as was recently proposed by Brookings Institution Fellow William Gale -- the average reductions in 401(k) accounts at normal retirement age would range from a low of 11.2% for employees now ages 26-35 in the highest-income groups, to a high of 24.2% for employees in that age range in the lowest-income group.

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At the hearing, Gale explained his proposal to "reform public policies toward retirement saving by replacing the current deduction for contributions to retirement saving accounts with a flat-rate refundable credit that would be deposited directly into the saver's account. The proposal would (a) address long-standing concerns in the retirement saving system by improving incentives for most households to participate and by raising national saving, (b) offset pressures created by the current weak economy for households to reduce their retirement saving, (c) help solve the long- term fiscal problem facing the country by raising $450 billion over the next decade in a manner that is consistent with the principles of broad-based tax reform and distributes the fiscal burden in a progressive manner."

Earlier EBRI analysis of the bipartisan deficit commission's other proposal to reduce the 401(k) savings caps to either $20,000 a year or 20% of income (the so-called "20/20 cap") starting in 2012, would most affect the highest-income workers -- not surprising, since those who earn more tend to save more using these kinds of retirement plans. However, EBRI also found the cap would cause a big reduction in retirement savings by the lowest-income workers as well. Today, the annual cap is $16,500, with an extra $5,000 allowed for those who are 50 and older.

Would Employers Drop 401(k) Plans?

All the proposed monkeying around with retirement savings plans could be one more nail in the retirement coffin. After all, the number often bandied about for how much money the average American will have at retirement is around $50,000 -- hardly enough to live the glamorous life in one's golden years.

VanDerhei told DailyFinance he's worried the Brookings proposal might find some support in Congress. "It promises to save the government $450 billion over 10 years, which could look attractive to the [Supercommittee that] is tasked with coming up with a lot of savings between now and Nov. 23."

Gale is leading the charge to make employers' contributions taxable and for employees to lose their 401(k) deduction. Instead, he suggests a flat-rate refundable credit of either 18% or 30% that would serve as a matching contribution to a retirement savings account. VanDerhei says this would surely diminish some employers' willingness to offer 401(k) plans, as well as employees' desire to participate in them.

Said VanDerhei, in a prepared statement, "Given that the financial fate of future generations of retirees appears to be so strongly tied to whether they are eligible to participate in employer-sponsored retirement plans, the logic of modifying (either completely or marginally) the incentive structure of workers and/or employers to save in a defined contribution plan needs to be thoroughly examined."

VanDerhei says it's not a stretch to think that too much tinkering could lead to some companies shutting 401(k) plans down. The consequences would be huge. "When people don't have 401(k)s, they often don't save elsewhere for retirement. Anything that will cause a drastic reduction in retirement savings at a time when there are various proposals to decrease Social Security benefits, makes it hard to see how people will have any standard of dignity in retirement."