Retirement savers everywhere should be alarmed. Rumors earlier this week point to contribution limits for 401(k) plans being cut all the way down to just $2400. The current contribution limit for 2017 is $18,000 and the limit for 2018 was recently announced at $18,500. The speculation comes from the tax reform that will try to make its way through Congress. Really the tax reform is just a magician’s slide of hand trick. Taxes get cut in hand A, you’re distracted by all the hype, and in hand money is taken out of your pocket to pay for the tax cuts.
Hey, I get it. Money can’t magically fall out of the sky to cover this country’s debts. For all you economics buffs, TINSTAFL – There’s no such thing as a free lunch. Basically look for the reforms to benefit large corporations and the upper class, while the middle and lower class foot the bill.
The real tragedy that happens for all Americans if this rumor comes into fruition, would be the chances of most regular people having any chance to comfortably retire significantly drops.
Let’s look at why this can’t happen.
First, while 401(k) plans are vehicles for mutual fund and insurance companies to milk retirement savers of fees, it is one of the best vehicles for saving and investing for retirement. It’s a great “pay yourself first” vehicle for people who otherwise would spend the money if it hit their bank account. I’ve unfortunately heard too often from people “If that money wasn’t coming out of my paycheck, I would have never saved for retirement”. Our instant gratification/consumption first, worry about paying later society is the American way. While socking away 10% of pay may not be enough to get you to retirement, it’s better than nothing (which is basically what $2400 is- NOTHING!).
Another reason this has to not happen is matching contributions. Think about your current retirement plan and the company match. My current 401(k) plan basically gives me a 4% match if I kick in 8%. Matching contributions are a no brainer, take it. Max out your plan if you can and work to maxing it out if you aren’t. If I am only able to put away $2400 into a 401(k), I can’t even get my full 4% match based on the plan rules. Suddenly my benefits at work have been cut.
Taxes are another reason 401(k) plans are so beneficial. Being able to do pre-tax contributions provides you an instant savings in taxes today and can potentially get you down into a lower tax bracket. Throw in tax deferred growth on your money and you’re heading in the right direction for building your nest egg. In my case, maxing the 401(k), HSA and traditional IRA enables me to drop into the 15% tax bracket and provides an additional benefit of not having to pay tax on my qualified dividends in my brokerage account. Lowering the limit to $2400, that can’t happen.
My final reasoning is the increased dependence on Social Security for retirement. Limiting 401(k) contributions to only $2400 increases Americans dependence on a program like Social Security, which itself is already stressed out. Will the government say, “Wow, our country is really bad at saving for retirement and real dependent on Social Security, we should increase social security taxes.” We know that no politician in their right mind will cut benefits, because that would lose them votes from every senior citizen. So what other possible solution can there be. Again, the money has to come from somewhere.
Let’s look at some figures to see how this would affect someone trying to save for retirement.
Let’s say someone enters the work force at age 25 and they work for 40 years. Say their pay is $50,000 (we won’t even adjust for inflation or COLA), and the 401(k) gives a 4% match if you contribute 8% (or $0.50 for each dollar they put in up to 8%). We’ll use an 8% rate of return during those years as well.
For our young worker starting out and knowing they really need to start early saving for retirement, they sign up on day 1 and max out the 401(k). The first issue they run into, $2400 represents a salary deferral of 4.8% for a contribution rate. Most likely, the employee can only select a percentage for their savings and not an actual dollar amount. So now our employee has to do just 4% deferral rate, because going over the limit contributing to a 401(k) subjects you to IRS penalties.
So day 1, our employee only contributes 4% or $2000 for the year. The matching dollar is now just $1000, so the employee is missing out on matching dollars as well.
Since, we’ve established how much is going into the account annually, we can now figure out the balance at the end of 40 years of working. So, socking away $3,000 a year for 40 years at 8%, returns a 401(k) balance of $777,169.55. Sounds decent, but remember inflation. That $777k in 40 years is only worth about $434, 039.08 in today’s dollars, and that’s using a super low inflation rate of 2%. I’m not even using my conservative 4% inflation rate I normally like to assume. At a 4% withdrawal rate, that puts income from the 401(k) at $17,361 or not nearly enough for your average person. Add on top, we have not sliced out any taxes or fees from the investments as well and we have a retirement crises that continues.
Let’s compare that to the current rules. Our employee maxes out at $18,000 and gets the full match of $2000 per year for 40 years at an 8% return. This works out to $5,181,130. In today’s dollars with a 2% inflation adjustment factor, that works out to $2,346,484. Based on a 4% withdrawal rate, producing income of $93,859. A much more comfortable position to be in.
What can you do if the change takes place
Basically the 401(k) would effectively be rendered useless. If the limit is reduced to $2400, the Roth or Traditional IRA becomes a much better option with the $5500 limit ($6500 for age 50 and older), but even that is not enough. Such a change to 401(k) plans would highlight the importance or regular non-qualified investment accounts such as individual or joint brokerage accounts. But then you have to be careful about your investment selection or you can run into adverse tax consequences of actively managed investments in these types of accounts.
It’s important to remember that you can reap the benefits of tax deferral in a brokerage account, but simply using a boring buy and hold investment strategy. It’s not 100% perfect, because you would pay a tax on dividends, but it becomes the next best alternative with a low 401(k) contribution limit.
You should also, try to max out your 401(k) as soon as possible. Sometimes rumors can come true. If not today, maybe tomorrow. We are not guaranteed the limits will be as high as they are today. Also, if tax reforms do happen and corporations are the big beneficiaries, don’t expect any job creation. Expect shareholders to benefit in the form of stock buybacks and dividend hikes.
Now, not to completely frighten you. I think the chance of this actually happening are pretty small. The investment and insurance companies would hate for this to happen and lots of politicians could lose out on money from their campaigns to get re-elected. I’m actually hoping the opposite rumor from late in the week happens of upping the limit to $20,000 for all. It is worth highlighting these rumors though. During President Obama’s second term, he caused quite the frenzy with the mention of changing the tax free withdrawals of 529 plans when used for college expenses, the very reason they exist. It caused quite the uproar and so should this chatter of such a low limit for 401(k) plans. It also highlights the fear among many Roth IRA holders that the government can change the tax free withdrawal status whenever they want. There is no guarantee, especially as the government looks for ways to increase tax revenues.
It’s sickening to think the government would use your 401(k) for negotiations of tax reforms that probably won’t have any real impact on your average citizen.Follow me on the social medias: