Two federal tax reform proposals could make them less attractive.

Our federal government needs to reduce its massive deficit – and among the many revenue-generating ideas being discussed in Congress, two in particular could have disturbing consequences for employees saving for retirement.

 There is no need to panic yet – these ideas are a long way from law. Still, a new report from the nonpartisan Employee Benefit Research Institute (EBRI) indicates that the bipartisan “super committee” of 12 legislators assigned to slash the deficit may be giving them at least a casual look.

 What if you couldn’t deduct 401(k) contributions? In September, representatives from the Brookings Institution proposed a remodel of current 401(k) plan rules at a Senate Finance Committee hearing. The big idea: end tax-deductible contributions to 401(k)s. Both employee salary deferrals and employer matches would be taxed. (Traditional IRA contributions would also be rendered taxable by this proposal.)1,2,3

 So by this concept, you would be taxed twice: once on your 401(k) contributions and once again on your 401(k) withdrawals.

 In apology, the federal government would provide employees (and their employers) with its own version of a match: qualified employer and employee contributions would be eligible for a flat-rate refundable tax credit which would be deposited directly into the 401(k). This credit would either be 18% or 30%.1,3

 We all know most people don’t save enough for retirement. How would being taxed twice encourage them? In January 2011, an EBRI poll found that 25% of employees would cut back on 401(k) contributions if they weren’t able to deduct them.1

 What if 401(k) contributions were capped? Another proposal – courtesy of the National Commission on Fiscal Responsibility and Reform – would put a ceiling on annual contributions to 401(k)s and other defined-contribution retirement plans. The so-called “20/20” modification would limit total annual employer and worker 401(k) contributions to either $20,000 or 20% of an employee’s income, whichever is lower. So this proposal could hurt low-income and high-income workers.3

 The “super committee” of 12 is under pressure to come up with a plan to hack $1.2 trillion off the federal deficit this month – and when it comes to preferential tax treatment in America, 401(k)s are a nice example. Would the committee dare get behind either of these proposals? Could any politician get reelected amid cries that (s)he wants to cap or double-tax your retirement savings?

 As Congress searches for revenue, the tax treatment of 401(k)s may get a second look – and a third. As EBRI research director Jack VanDerhei told a reporter from the financial services industry website AdvisorOne, “I can virtually guarantee that the whole concept of [401(k)] tax preferences will be reexamined in 2012 and 2013.”1

 

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Citations.

1 – www.advisorone.com/2011/11/11/deficit-tax-proposals-would-radically-change-401ks [11/11/11] 

1 – www.advisorone.com/2011/11/11/deficit-tax-proposals-would-radically-change-401ks [11/11/11] 

2 – www.ebri.org/publications/ib/index.cfm?fa=ibDisp&content_id=4934 [11/11]      

3 – www.ebri.org/pdf/briefspdf/EBRI_IB_11-2011_No364_RetTaxRfm.pdf [11/11]