Social Security is at risk. Public pensions are in shambles. And although 401(k) balances have recovered much of the ground they lost during the market meltdown, policymakers have proposed reforms that could potentially spell disaster for your retirement savings plan.
The wrong place to cut
The National Commission on Fiscal Responsibility and Reform has the difficult job of trying to navigate through the nation's huge fiscal deficit to find a solution to close the gap between how much the government spends and how much revenue it takes in. Along the way, it has made several controversial proposals, such as capping all discretionary spending for the next 10 years and eliminating all special tax subsidies for businesses. Another proposal argues for moving to a territorial tax system in order to avoid the offshore tax-deferral programs that companies including Amgen (Nasdaq: AMGN ) , Oracle (Nasdaq: ORCL ) , and Bristol-Myers Squibb (NYSE: BMY ) have used to shelter billions in cash from immediate U.S. tax.
But one proposal from the Commission that's aimed directly at 401(k) savers misses the mark. Although its clear goal is to limit the amount that high-income taxpayers set aside in their retirement plans, it also unnecessarily places huge restrictions on lower-income taxpayers at a time when they need to save as much as they possibly can.
What the cut does
As the Employee Benefit Research Institute describes the plan, the Commission would recommend a cap on the maximum amount that workers can contribute to 401(k) plans and get a current tax deduction. The limit would be the lesser of 20% or $20,000 annually.
Now if you're familiar with 401(k)s, that upper limit may not seem to be relevant. Under current law, the most that a worker under age 50 can set aside is $16,500. But what many don't realize is that executives often get substantial contributions from their employers above and beyond what they set aside from their own salaries -- as high as $49,000. Self-employed individuals with their own solo 401(k) plans can also take advantage of those higher limits.
Limiting high-income individuals is one thing. But what doesn't make sense is the 20% limitation on lower-income taxpayers. As the EBRI's research shows, this arbitrary cap would cut eventual 401(k) balances for the 25% of taxpayers with the lowest incomes by a much greater percentage than those closer to the average income.
Reversing course
Given all the economic challenges that low-income families face, the last thing the government should do is to discourage workers from putting money aside for retirement. Yet the change would be a huge reversal from current law, because right now, those who earn as much as $55,500 may qualify to receive a Retirement Savings Contributions Credit of up to $2,000 for contributing to an IRA or 401(k).
Moreover, with the right incentive, it's easier than ever to invest on a budget. ETF providers like BlackRock (NYSE: BLK ) , State Street (NYSE: STT ) , and Vanguard have full sets of exchange-traded funds to give investors with minimal funds a chance to buy into the broad stock market. And with commission-free ETF trading from Schwab (NYSE: SCHW ) , TD AMERITRADE (Nasdaq: AMTD ) , and a host of other discount brokers, buying those ETFs doesn't have to cost you an arm and a leg every time you trade.
It affects you
Meanwhile, even if you're not in that bottom 25% of income earners, don't deceive yourself into thinking the law doesn't really matter to you. Sure, you might be able to keep contributing exactly what you already do, but a family that can't use tax-favored retirement accounts to help support themselves may well end up being a family that needs government assistance in their old age -- assistance that you'll end up paying for.
America was built on the idea that everyone has a fair shot at reaching prosperity. Changing tax laws in the name of balancing budgets is a laudable goal, but doing so on the backs of the economically challenged is a recipe for long-term ruin. Rather than putting obstacles in the path of the poor, giving them incentives to do the right thing with what money they have can help them dig their way out of financial insecurity.
Learn everything you need to know about IRA and 401(k)s in our Retirement Center.
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