Tax reform – 401K

Let’s talk taxes. Recently the House Republicans proposed lowering the maximum deferral amount on 401K plans from $18,000 to $2,500 in order to raise the revenue needed to pay for the tax breaks in the plan such as lower rates. President Trump has said he will not go along with that change.

This is an area I know something about, although I’m not nearly as current as I used to be. I was a research assistant for my tax professor in law school and worked for an accountant during tax season, but that was almost 50 years ago. More recently, I handled tax matters for the Valley Transportation Authority (VTA) from 2001 to 2006, almost exclusively dealing with the retirement plans. But I’m no expert on the details and haven’t kept up. What I do understand are the basic policy issues.

What the 401K and similar federal retirement plans, such as 403(b) and 457 plans are designed to do is to encourage people to save money toward retirement. Such savings benefit both the individuals and all levels of government by reducing the dependence people might have on government programs like Social Security or other forms of public assistance. They do this by allowing people to put money in these programs before tax, i.e. so it is not included in their taxable income at the time it is earned, but is later when withdrawn, typically at or after retirement age. This provides a benefit to the taxpayer in three ways. First, current taxes are lowered and that income can then be preserved. Second, the earnings in those plans such as dividends and interest are also not taxed at the time they are earned, although they are later. This allows them to grow faster. Third, the taxpayer is likely to be in a lower tax bracket when he finally withdraws the money and is taxed on it. There are limits on how much income individuals can defer in these plans (benefit #1) and how much in total each year (which can help with benefit #2 even if taxes must be paid over the first limit). The exact amounts may vary for individuals depending on the plans, their age, their work longevity, how much they’ve deferred in the past, and whether they are “highly compensated” under IRS rules. I won’t bother with those details. For the current policy debate the main number under consideration is that $18,000 deferral amount for the average individual.

In my judgment, the deferral plans work as intended for most middle class people. People save more because of these rules and everybody wins. However, they help wealthy people even more. That’s because the deferral limits are set too high in my opinion. I support the GOP proposal. The fact is most middle class individuals can’t save $18,000 a year, tax-deferred or not. The U.S. Census Bureau reported in September 2017 the real median household income was $59,039 in 2016. That’s a household, which on average has more than one wage earner. For a two-earner family that would mean they could defer $36,000. The permitted deferral amount would be 61% of their gross income. I doubt you will find many families earning $59K who can put over 60% of their earnings into savings. They need their salaries for such necessities as rent, food, clothing, and medical care.That’s not even counting the fact they’ll have to pay federal and maybe state income taxes on the rest of it. The GOP proposal of $2,500 (or $5,000 for husband and wife) is probably a reasonable amount for the typical middle class family. Everything above that is really a benefit for the upper middle class or the very wealthy.

I know that when I reached my peak earning period in my 50’s I maxed out my contributions. Because I was working in a government agency I could contribute to both a 401 plan and a 457 plan and had the option of contributing even more under the “catch up” rules. Frankly, it was an unfair benefit for me. Other, lower-paid taxpayers had to take their salaries to live on, and paid their taxes immediately as a result, while I was stashing mine away untaxed. The tax code requires that I withdraw amounts every year starting soon, so I’ll be paying some taxes, but I doubt I’ll ever withdraw my entire deferred amounts. My wife can inherit it tax-free and my kids will probably get a big chunk of it. Under current rules they can open an inherited IRA and defer the taxes on that yet again. I think this is unfair to lower-paid taxpayers. With lower deferral limits, the wealthy would finally have to pay taxes when the money is earned, but of course could still save as much as they want and can afford and wouldn’t be taxed on it later. The GOP is not known for taxing the rich to help the middle class, but in this case, they should be supported for trying to do so. Let’s hope the president changes his mind.

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