Plan to Limit a Retirement Tax Break for the Rich Could Hit the 99% Too

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In trying to save for retirement, tax-favored retirement accounts like IRAs and 401(k)s are valuable tools. They give savers tax benefits for putting money into retirement accounts and let them profit from those investments without having to pay taxes until they withdraw the money in retirement.

But some policymakers are concerned that the wealthy are taking unfair advantage of IRAs and 401(k)s, accumulating extremely large balances in them tax free. In order to rein in that abuse, the Obama administration proposed earlier this year to limit the amount of money that you can hold in tax-favored retirement plans.

Essentially, the plan would cap your the size of a retirement account at an amount that would allow a person to buy an annuity that pays out $205,000 a year, at that year's prevailing interest rates. So the cap is variable, depending on how interest rates move. (Why $205,000? It's already the federal limit for defined-benefit pension plan annuities.)

Based on those numbers, the initial cap would have been $3.4 million in April, which makes it clear the proposal is aimed at only the wealthiest of Americans. Yet further analysis shows that the proposal could actually affect a much wider swath of the American population, thanks to unintended consequences that could make it harder for millions to save for retirement.

Hitting a Moving Target

The nonpartisan Employee Benefit Research Institute recently took a look at the administration's proposal, seeking to figure out its impact both now and in the future. The study found that in the short run, implementing the balance cap would affect a very small number of savers.

Over time, though, the impact would be much larger. The EBRI found that even if interest rates remain the same as they are now (and they won't), more than one out of every 10 401(k) participants would be likely to reach the proposed limit at some point before they reach age 65.

%VIRTUAL-article-sponsoredlinks%The effect is even bigger if you make some realistic assumptions about the future direction of interest rates. Rates are important because the proposal doesn't refer directly to a total-balance limit but rather ties it to what an equivalent pension plan would produce in annual income. If rates rise, then the $3.4 million figure would drop. Specifically, if the interest rates used to determine the limit were to double, between 20 percent and 30 percent of savers could end up being affected by the limits.

Cutting Off Small-Business Employees

Having maximum balances for IRAs and 401(k)s is problematic, but it would still allow savers to get sizable benefits from tax-favored retirement accounts. However, a second-order effect of retirement-account limits could actually prevent many workers at small businesses from having any access to 401(k) plans.

The EBRI noted that in many cases, small businesses establish retirement plans in order to give their high-income owners the maximum ability to save money on a tax-deferred basis. If such business owners were to hit the maximum limit allowed under the new proposal, however, they might decide that it no longer made any sense to keep offering plans to their employees. If owners terminated their plans, their workers would lose access to the 401(k) retirement savings option.

The analysis is built on many broad assumptions, making it hard to reach firm conclusions. But under one set of conditions, between 30 percent and 40 percent of participants could suffer reduced 401(k) balances when you take the possibility of businesses terminating their retirement plans into consideration.

In particular, younger workers could be hit the hardest. With the most time to accumulate assets and reach the retirement savings limits, the EBRI found that as many as 70 percent to 80 percent of employees aged 26 to 35 would see some reduction in their 401(k) balances by the time they reach age 65.

Be Smart About Retirement Savings

The EBRI's findings show how hard it is to craft legislative proposals to reach what seem to be desirable ends. Even with the intent of reducing abuse of retirement plans, these limits could end up hampering the retirement prospects for millions of Americans. Regardless of what happens with this proposal, you can expect the battle over tax-favored retirement accounts to continue well into the future.

You can follow Motley Fool contributor Dan Caplinger on Twitter @DanCaplinger or on Google+

Originally published