Data & ResearchNovember 9, 2011

EBRI: Tax Reform Proposals Likely to Reduce 401(k) Balances

Two recent proposals to change the <span>existing tax treatment of 401(k) retirement plans, if enacted, are likely to result in lower account balances for many 401(k) participants, according to the Employee Benefit Research Institute (EBRI).</span>

Reported by PLANADVISER staff

EBRI reports that currently, the combination of worker and employer contributions to a 401(k) plan is capped by the federal tax code at the lesser of $49,000 per year or 100% of a worker’s compensation (participants over age 50 can made additional “catch-up” contributions). As part of the effort to lower the federal deficit and reduce federal “tax expenditures,” two major reform proposals have surfaced that would change current tax policy toward retirement savings:

A plan recently presented at a Senate Finance Committee hearing that would end the existing tax deductions for 401(k) contributions and replace them with a flat-rate refundable credit that serves as a matching contribution into a retirement savings account.
The so-called “20/20 cap,” included by the National Commission on Fiscal Responsibility and Reform in their December 2010 report, “The Moment of Truth,” which would limit individual annual contributions to either $20,000 or 20% of income, the so-called “20/20 cap.”

The analysis is based on EBRI’s proprietary Retirement Security Projection Model, and is published in the November 2011 EBRI Issue Brief, “Tax Reform Options: Promoting Retirement Security.”

EBRI determined that the impact of permanently modifying the exclusion of employee contributions for retirement savings plans from taxable income the average reductions in 401(k) accounts at Social Security normal retirement age would range from a low of 11.2% for workers ages 26‒35 in the highest-income groups to a high of 24.2% for workers in that age range in the lowest-income group.

The impact of the "20/20 Cap” would most affect those with high income (see “Capping Tax-Preferred 401(k) Contributions Would Hurt Workers”). However, EBRI also found the lowest-income group has the second-highest average percentage reductions in retirement contributions, and that younger cohorts would experience larger reductions given their increased exposure to the proposal. For each of the age groups analyzed, the highest-income group shows the largest average percentage reduction in account balance, ranging from 15.1% for the highest-income group for those currently ages 36–45 and falling to 8.6% for the highest-income group for those currently ages 56–65. However, other than for those with the highest income, those in the lowest-income group showed the second-highest average percentage reductions

"Defined contribution plans, such as 401(k)s, and the IRA rollovers they produce, are the component of retirement security that seems to be generating the most non-Social Security retirement wealth for Baby Boomers and Gen Xers," said Jack VanDerhei, EBRI Research Director and author of the report. "The potential increase of at-risk percentages resulting from (1) employer modifications to existing plans, and (2) a substantial portion of low-income households decreasing or eliminating future contributions to savings plans as a reaction to the exclusion of employee contributions for retirement savings plans from taxable income, needs to be analyzed carefully when considering the overall impact of such proposals."

To view the analysis, visit http://www.ebri.org.