Two recent proposals to change the existing tax treatment of 401(k) retirement plans, if enacted, are likely to result in lower account balances for many 401(k) participants, according to a new analysis by the Employee Benefit Research Institute.
Currently, the combination of worker and employer contributions to a 401(k) plan is capped by the federal tax code at the lesser of $49,000 per year or 100% of a worker's compensation (participants over age 50 can made additional "catch-up" contributions). As part of the effort to lower the federal deficit and reduce federal tax expenditures, two major reform proposals have surfaced that would change current tax policy toward retirement savings:
1. A plan recently presented at a Senate Finance Committee hearing that would end the existing tax deductions for 401(k) contributions and replace them with a flat-rate refundable credit that serves as a matching contribution into a retirement savings account.
2. The so-called "20/20 cap," included by the National Commission on Fiscal Responsibility and Reform in their December 2010 report, "The Moment of Truth," would limit individual annual contributions to either $20,000 or 20% of income.
"Defined contribution plans, such as 401(k)s and the IRA rollovers they produce, are the component of retirement security that seems to be generating the most non-Social Security retirement wealth for baby boomers and Gen Xers," says Jack VanDerhei, EBRI research director and author of the report. "The potential increase of at-risk percentages resulting from employer modifications to existing plans, and a substantial portion of low-income households decreasing or eliminating future contributions to savings plans as a reaction to the exclusion of employee contributions for retirement savings plans from taxable income, needs to be analyzed carefully when considering the overall impact of such proposals."
According to VanDerhei's research, the effect of the first proposal - if the current exclusion of worker contributions to retirement savings plans were ended in 2012 and the total match remains constant - on the average reductions in 401(k) accounts at Social Security normal retirement age would range from a low of 11.2% (among the highest income group) to a high of 24.2% (the lowest income group) for workers age 26 to 35.
Regarding the impact of "20/20 cap," an earlier EBRI analysis showed it would most affect those with high income. However, EBRI also found the lowest-income group has the second-highest average percentage reductions in retirement contributions, and that younger participants would experience larger reductions given their increased risk exposure under the proposal. For each of the age groups analyzed, participants age 36 to 45 in the highest-income group show the largest average percentage reduction in account balance at 15.1%, compared to 8.6% for the highest-income group among participants age 56 to 65. Those in the lowest-income group showed the second-highest average percentage reductions.
A recent survey of small and midsized employers, meanwhile, reveals that two out of three plan sponsors believe the current 401(k) system is effective in helping employees achieve adequate retirement savings, despite frequent reports that show employees are ill-prepared for retirement and not saving enough.
"Employers think that the 401(k) platform can be a successful platform, but they also recognize that the savings rate needs to be higher and there are more things they can do through plan design," says Greg Burrows, senior vice president of retirement and investor services with The Prinicipal Financial Group, which published the survey.
The 2011 Principal Financial Group Retirement Readiness Survey questioned 1,305 benefits professionals; some offered defined contribution plans and some did not.
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