Danger Ahead?

Considering the fiscal cliff and the country’s ballooning debt, it’s no surprise legislators must make unpopular decisions in the coming months—but will one of those decisions involve the government taxing a larger portion of retirement savings upfront?

An initiative from the Simpson-Bowles deficit-reduction panel, called the 20/20 Cap, proposes expanding the tax base via a limit of the lesser of 20% of an employee’s compensation or $20,000 in annual total employer and employee retirement plan contributions. The key word is total—the total combined maximum contribution of $20,000 would include employer contributions, currently limited to $50,000.

A ‘Timing Issue’ 

Randy Hardock, representing the American Benefits Council, testified before the U.S. House of Representatives Committee on Ways and Means that any short-term revenue gain that might be derived from changes in the retirement tax incentives is “largely illusory” and cannot responsibly be used to offset the costs of reducing tax rates or other long-term government initiatives.

Hardock contended that the revenue scoring performed by the Treasury Department and the Joint Committee on Taxation generally produces estimates in five- and 10-year budget windows using a cash-flow analysis.

“Under that methodology, the taxes an employee will pay when he or she retires and starts taking taxable plan distributions generally occur outside the budget window,” Hardock’s April testimony continued. “Proposals that reduce retirement savings today will mean the government actually collects less revenue in years outside the budget window because retirees will have less taxable retirement income. As a result, total long-term budgetary savings that might result from scaling back the existing retirement savings tax incentives would be considerably smaller than the short-term revenue estimates might suggest.”

It is a gain, but only in the short term, emphasizes Judy A. Miller, chief of actuarial issues and director of retirement policy at the American Society of Pension Professionals and Actuaries (ASPPA). “Down the road, when people pull it out, there is less money to tax,” Miller says.

Charitable or mortgage interest deductions are just based on one year, but when money is excluded on deferrals, the tax is deferred. The initiative treats it as tax-basis cash incentives—and ignores the fact that tax revenue will be coming down the road, she says.

“You’re losing revenue later,” Miller says. “To some degree, it’s a shell game. If people save less, they may have to lean more heavily on government supports. It’s an unbelievably bad idea.”

Diminished Incentive 

Some retirement industry experts are also concerned that the cap would lessen tax incentives for employers to sponsor retirement plans. Small-business owners, in particular, may stray from offering a company-sponsored 401(k) plan if the initiative comes to fruition. Although the 20/20 Cap would most affect highest-income workers, sources say it could have an impact on all employees.

“When a typical small-business owner evaluates the significant legal responsibilities, risks and costs of plan sponsorship, it is often the promise of meaningful tax benefits for key employees that is the deciding factor in choosing to maintain a retirement plan,” Hardock noted, in his testimony.

“If tax benefits to decisionmakers are substantially diminished, businesses that would have considered plan sponsorship will no longer do so, and existing plan sponsors will reduce matching contributions or stop offering retirement plans altogether,” he said. “All employees will suffer.”

The vast majority of savers would be untouched by a reduction in contributions, says David John, senior researcher with the Heritage Foundation. Nevertheless, John has very strong questions about the proposal. “This goes in the wrong direction,” he says. “If this was implemented, it could reduce the amount of savings in the economy. It doesn’t take too many individuals to reduce the aggregate amount of savings.”

‘Devastating’ 

Advocacy organizations are responding to the proposal with alarm. “It would be hard to describe just how bad we think [the proposal] would be,” ASPPA’s Miller says. “It would really devastate the retirement savings system.

“Most people are more likely to save if they save at work,” he says. “This is very well-documented. Current tax incentives encourage people to save, and they encourage employers to set up savings programs.”

Michael Kozemchak, managing director of Institutional Investment Consulting in Bloomfield Hills, Michigan, says he realizes legislators must make difficult decisions to address the deficit, but limiting 401(k) contributions could have dire consequences. “The 401(k), if you will, is the last ‘safe frontier,’” he says. “I think this [proposal] would turn America’s retirement security on its head.”

Fred Reish, chairman of the Financial Services ERISA (Employee Retirement Income Security Act) team at Drinker Biddle & Reath LLP in Los Angeles, agrees that the 401(k) is the ideal safe place for employers; unlike with defined benefit (DB) plans, employers can halt or decrease contributions in a bad economy while continuing employee access to savings.

If the 20/20 Cap is enacted, it would create a compelling case for plan sponsors to perform a cost/benefit analysis to determine whether offering the retirement plan would be worth the money and administrative hassle, Kozemchak says. That “will give pause to most employers as to whether they would want to continue [sponsoring a plan],” he says.

The $20,000 cap might be enough for rank-and-file employees or mid-managers to accumulate a reasonable retirement, but for higher-level execs and business owners it will not be enough to replace their income, Reish says.

According to Miller, the proposal is, in effect, telling participants, “Save less,” while discouraging employers from offering retirement savings plans in the first place. “Back in the ’80s, they cut into the limits on DB plans, and there was a flurry of plan terminations by employers,” Miller points out. “I think the same thing would happen with 401(k) DC plans if this were adopted.”

Small-business owners, in particular, would be deterred from setting up 401(k) plans because of the hassle. “It hurts small businesses, period. It’s mathematically obvious,” Reish says. It may also hurt large businesses; if plans become less attractive, less support and resources may be given to maintain quality 401(k) plans at those companies.

Not as Dire as Predicted 

John says more data is needed about whether the proposal would act as a disincentive for employers to offer retirement plans. “The understanding is that, especially for smaller employers, with the antidiscrimination tests, they are likely to start a retirement savings plan because they themselves benefit from it, because they’re paying themselves more than their employees.”

Other organizations say the dangers of capping retirement plan contributions are being overstated. Two-thirds of these and other tax breaks go to taxpayers in the top income quintile—households with more than $103,000 in income in 2011, according to Monique Morrissey, an economist at the Economic Policy Institute.

“Aside from the fact that upper-income households need less help saving for retirement than low- and middle-income households, these tax breaks do little to increase saving, since most high-income households already save and simply steer funds to tax-favored accounts,” Morrissey says on the Economic Policy Institute’s website.

An alternative to implementing the 20/20 Cap is eliminating the mortgage interest deduction. “[Legislators] are going to have to do something very unpopular,” Kozemchak says. Another option is eliminating the mortgage interest deduction on a second home, Reish says. This would be a legitimate alternative because it is low on the government’s priority list compared with education, defense and health care and affects fewer people, he says. 

How to Take Action

Reish suggests that those opposed to the 20/20 proposal take action by writing a letter or emailing, calling or meeting in person with their local congressman. Even if you do not directly speak with the representative, chances are the message will be relayed to him, Reish says.

If you belong to a trade association—particularly if you are active in it—Reish says it is important to make sure the association is expressing its opinion about the 20/20 Cap. Trade associations have significant influence because they are seen as organizations that represent the views of many people, he says.

On November 12, ASPPA launched a campaign and website, savemy401k.com, to promote the benefits and the tax breaks of workplace savings. The campaign asks ASPPA’s 10,000 members to join forces with 401(k) participants to send 250,000 emails to federal lawmakers. As ASPPA Executive Director and CEO Brian Graff says, it is critical for the retirement industry to let its aversion to less favorable 401(k) tax treatment be widely known.