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Retirement Pros Reveal Worst Fears Regarding Tax Reform

Retirement Pros Reveal Worst Fears Regarding Tax Reform
October 24
01:01 2017

Both the mainstream and the trade media have featured many reports (often unsourced) about impending changes to 401k savings plans coming in the new tax reform bill. Whether its “Rothification” or “Reducing Contribution Caps,” it’s clear there’s rampant anxiety in the ranks of the retirement industry. The good news is both the Senate version and President Trump have ruled out these changes. Until the House comes out with its version of tax reform, speculation continues to run rampant, leaving many to wonder, “What policy change would be most detrimental to retirement savings?”

We spoke with retirement professionals across the country to gauge their worst fears regarding the potential impact on retirement savings as a result of certain specific tax reform changes. The experts universally agree any reduction of tax benefits would likely harm retirement savings. “For some people, it’s the only reason they participate,” says Ilene Davis of Financial Independence Services in Cocoa Florida and author of Wealthy by Choice: Choosing Your Way to a Wealthier Future.

Indeed, lowering or removing tax-deductibility of a majority of contributions hurts the very people who can least afford it – those who don’t make enough to overcome the loss of the incentive yet who make too much to avail themselves of government assistance programs. “According to National Association of Plan Advisors, almost 80% of participants in 401k and profit sharing plans make less than $100,000 per year (43% make less than $50,000),” Andy Bush, a Partner/Advisor in the Retirement Plans Division of Horizon Wealth Management in Baton Rouge, Louisiana. “These people prefer the deductibility now so they can use the tax savings to help support the other expenses in their lives.”

Any public policy change that discourages retirement savers will alter the current trend among some to attain the financial self-sufficiency needed to offset expected reductions in Social Security. “The worst possible change is reducing (or even eliminating) the ability to fund a retirement plan with pre-tax dollars,” says Reza Zamani, CEO of Steel Peak Wealth Management in Los Angeles California. “The whole idea of a 401k being in place is to promote individuals to plan for their own retirement and rely less on the government Social Security system.”

Still other policy changes could have long-term implications in the ability of Americans to retire in comfort. “Eliminating tax deferred growth would be the worst change Congress could make,” says Jason J. Howell, President of Jason Howell Company in Vienna, Virginia. “The compounding effect of growth associated with not paying taxes in retirement vehicles is too important.”

The most cynical fear Congress might make changes retroactive, effectively removing tax advantages from decisions made years ago. The kind of tax “bait and switch” primarily affects Roth plans. “In my opinion, the worst change Congress could make is to remove any type of Roth features from 401k or Roth IRA plans without grandfathering in existing contributions,” says Dan Kellermeyer, Financial Planner at New Heights Financial Planning in Sioux Falls, South Dakota. “This would mean gains on the post-tax contributions you made to your Roth plan would become taxable upon distribution.”

While much has been written of the lack of retirement savings among Americans, the most widely talked about change – lowering the cap on tax deductions – could exacerbate the lack of retirement savings, even if the new policy points the retirement saver towards a better (albeit one without an immediate tax deduction) alternative. “People have a strange way of being tax focused rather than life focused,” says Howell.

If there’s anything we’ve learned from behavioral finance, it’s that, despite the current incentives, people still don’t always act in their own best interests. “It will hurt retirement savings,” says Davis. “Too many only save through a plan at work. Considering the number of supposedly educated people who don’t take advantage when a company provides matching dollars, making it even more difficult for those that do save the max only hurts the country as a whole in the long run.”

Reza Zamani, agrees, saying, “the major incentive for contributions to a traditional 401k are that the investor gets to use pre-tax dollars and the money grows tax deferred.”

We already know people prefer the convenience of saving through a 401k plan rather than an IRA (that’s why the 401k went viral in the 1980s while IRAs, which had been around longer, did not). “Lowering the cap on tax donations would force savers to contribute to other types of retirement savings accounts like IRAs or Roth IRAs, which already have a low cap on annual savings,” says Kellermeyer. While savers would have more stocks and mutual fund options with these accounts, one benefit to a 401k is the ease of contributions through salary deductions. This could cause savers to be more frustrated and put off retirement savings even further.”

On the other hand, if Congress calculates correctly, adjusting the cap might only impact higher earners. “To my point above, according to the Plan Sponsor Council of America, the average worker put 6.8% of their salary into 401k plans in 2015 (a 10% increase from the previous year),” says Bush. “But let’s do the math: If almost 80% make less than $100k, 6.8% would equate to less than $6,800. Congress was considering allowing the first half of the limit ($18,500 in 2018) to be a pre-tax contribution and the second half a post-tax ROTH contribution. So, more than likely, the most effected would be those who are making larger salaries. Vanguard finds that just 12% of plan participants are contributing the maximum amount they’re allowed to contribute every year – these are the guys/gals who it would affect. I’m not suggesting that Congress making that change won’t hurt retirement savings, but it could hurt discretionary spending.”

Although much of the talk has focus on individual victim, a cap on taxable deductions could harm small businesses worse, but only if that small business can’t afford to increase matching. Kellermeyer says, “I don’t think it necessarily hurts these businesses. If an employee can only contribute $2,400 a year instead of $18,000, an employer could increase their matching percentage and still contribute less overall to the account.”

That’s a big “if,” though, as smaller businesses generally don’t have the largess of cash flow to simply increase the match. “Small businesses would lose employees to larger companies who could afford a larger employee investment,” says Howell.

Of course, many small businesses don’t even offer a match in the first place. With employees saving less because of a cap on contributions, this means there’s no mechanism to make up for the reduced savings. “Small businesses generally do not provide a match,” says Zamani, “so by lowering the taxable deductions, this would make investors set aside less money and therefore the risk to a proper retirement increases.”

If these types of policy changes are so obviously bad for America, why, then, would Congress float the idea? “Tax revenue,” says Bush.

In the static financial modeling used by the government, reducing tax deductions in one area results in a straight-line increase in tax revenue. There’s no assumption that people might change their behavior to avoid these new taxes. “By capping deductions,” says Kellermeyer, “Congress simply hopes to increase their tax revenue. The less a taxpayer can deduct, the more they will owe in taxes.”

Congress needs to raise short-term revenues because, in failing to repeal ObamaCare, it failed to generate the anticipated savings that could have been used to offset the tax cuts they want to make. They need to find that offsetting revenue from other sources, and the nation’s multi-billion dollar retirement savings represents an inviting target. “The need to provide some way of generating additional tax revenue today to offset the tax savings they are promoting by lowering the income tax bracket overall,” says Zamani. “This tax plan only works if there is significant growth over the next 10-20 years; the lowering of the cap on taxable deductions will ease the pain short term, but cause more pain with retirees having less money during retirement.”

Some see their motives as less than pure. “They are selfish and want more people dependent on government to make it easier to buy votes,” says Davis. “I think Congress should not have either a pension plan or a thrift savings plan. Let them save on their own.”

We don’t know if these policy changes are real or merely being floated as part of a grand negotiating strategy. Trump is well known as a negotiator who always opens with an initial ask far greater than what he’s willing to accept. Perhaps Congress is catching on to this tactic.

Christopher Carosa is a keynote speaker, journalist, and the author of  401(k) Fiduciary SolutionsHey! What’s My Number? How to Improve the Odds You Will Retire in Comfort and several other books on innovative retirement solutions, practical business tips, and the history of the wonderful Western New York region. Follow him on Twitter, Facebook, and LinkedIn.

Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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