The Miser’s 3 Things:
- The House and Senate tax bills impose no new restrictions on 401(k) contribution limits for millennials — for now
- New 401(k) rules would’ve had a negative impact on the amount people save for retirement, experts say
- And funneling people into Roth account would harm those looking to diversify their retirement savings
Many followers of personal finance news cheered over the past two weeks when House and Senate Republicans unveiled competing tax cut plans and neither included major changes to most savers’ 401(k) contribution limits.
The House version makes no changes to the limits at all; an amendment to the Senate bill would change how workers over age 50 make “catch-up” contributions, CNBC reported.
A plan that didn’t make it into the House or Senate’s proposals would’ve reduced the amount a person can contribute to his or her 401(k) each year from $18,000 to $2,400. Presumably, contribution limits on Roth IRAs would’ve been increased to offset this.
These dramatic 401(k) changes would’ve fundamentally altered how Americans save for retirement. They could, of course, still be inserted as the GOP tries to fold its two plans into one that can pass both houses of Congress.
Why change the 401(k)?
You contribute to your 401(k) with pre-tax money. In other words, the government doesn’t take its cut until you withdraw your money — hopefully at retirement, and not sooner. For millennials, that day is 30-50 years away.
Roth IRAs, on the other hand, are funded with after-tax contributions. The government takes its cut of your paycheck, and then you fund your Roth. It has tax advantages on the back-end, because you withdraw your money tax-free when you retire.
An infusion of tax revenue from scaling back pre-tax 401(k) contribution limits would’ve helped congressional Republicans pay for proposed business and individual income tax cuts. However, personal finance experts have criticized the limit idea as a short-term solution, or even a gimmick.
Consequences for savers
Contribution rates being equal, a Roth takes more of a bite out of your biweekly paycheck than a contribution to your 401(k), because the 401(k) has the advantage of reducing your taxable income.
In other words, it’s easier for many workers to contribute to a 401(k) and still have money leftover to pay the bills.
The concern: placing dramatic limitations on how much you can contribute to a 401(k) and funneling people towards Roth accounts would have a negative impact on retirement saving.
Many people would save less or not at all, because it would strain their budgets to contribute the same amount of after-tax dollars to retirement accounts. We already have a difficult time saving in our 401(k)s.
Impact on diversification
For “super-savers” — people who’d contribute a lot regardless of whether the law changes — there’d be a different consequence.
Currently, some financial planners will say to contribute first to your 401(k) to get the maximum company match and avoid leaving free money on the table. For many companies, this is 50 percent of your first 6 percent of contributions. In other words, you’d contribute 6 percent of your pre-tax income and get 3 percent.
Financial planners would then tell you to switch to a Roth IRA and contribute up to the $5,500 annual max. If you have anything left over, return to the 401(k) and save up to the $18,000 personal contribution max.
The reason they teach this is to take advantage of diversification.
Usually, we hear this word for investing: Make sure your accounts include a mix of stocks and bonds, small companies, large companies and overseas companies. That way, you don’t have all your eggs on one basket if one sector of the market drops.
There’s tax diversification, too. Many people will live on a smaller income in retirement than they do now. A 401(k) works well for them, because they’ll pay less income tax when withdrawing the money in retirement than at their current, higher tax rate.
Others will live on a larger income in retirement than they do now. For them, Roth accounts are great. You’ve already paid taxes on that money at your current, lower tax rate; when you withdraw your contributions upon retirement, it’s tax-free income.
If people were forced to save the vast majority of their retirement money in Roth accounts, it will not allow this diversification to happen. Many people would’ve paid more taxes on the money before making contributions than they would’ve to withdraw it in retirement.