Tax-advantaged plans are popular ways to save for retirement. However, rules for these plans can change, and one recent proposal from President Obama is getting a lot of attention.
In his most recent budget proposal, Obama proposed a limit on what point people can contribute more money to tax-advantaged retirement plans such as 401k plans.
The proposal calls for stopping additional tax-advantaged plan contributions once there is enough money in the plan to generate $210,000 in annual income. Currently, this would mean no more additional contributions once the plan has about $3.4 million.
But the proposal is not creating a government-imposed cap on total retirement savings; it's only limiting additional contributions to tax-advantaged plans beyond a certain point. In this respect, the proposal is not a total savings cap but a cap on what point no more contributions to certain plans are allowed.
Proponents argue that people with so much money already saved away don't need additional tax breaks in the form of a tax-advantaged plan. After all, the proposal is a cap preventing new plan additions, holders of these plans can still save and invest through accounts that aren't tax advantaged. While they won't get the tax benefits of a tax-advantaged plan, proponents don't think savings above $3.4 million need extra tax breaks.
Opponents take the view that the government should encourage savings for retirement and people using tax-advantaged plans are just doing what is best for themselves. They also argue that $210,000 per year may not be enough for some individuals, especially those living in high-cost areas. Another point they put forth is that extra savings provide extra protection; after all, $3.4 million could be far less in the event of a market crash.
Will it pass?
Like so many other proposals in Washington, this one faces an uphill battle to being implemented. Obama's budget has drawn the expected criticism from the Republican side, and with Republicans controlling both houses of Congress this proposal is unlikely to become law.
Looking back at previous budgets, it's clear this tax-advantaged plan limit is not a new idea for the 2016 budget. Similar proposals were also contained in the 2014 and 2015 budgets -- and neither time were passed into law.
So, like it or not, passage of this proposal seems unlikely as past attempts have failed and the composition of Congress is more Republican than it was during the last budget proposals.
What should you do?
If this proposal has you considering abandoning your tax-advantaged retirement plan, you should think twice before doing so.
Unless you have amassed a seven-figure plan, the proposal would not even affect your current holdings if it passed. According to data from Fidelity Investments, only nine percent of 401k owners had more than $2 million in their account last year. This means there are plenty of people out there who still have lots of room to invest before even hitting the potential cap.
Best tax-advantaged retirement plan investments
In effect, these tax-advantaged plans are tax breaks for those willing to make use of them. So just as you hunt for every deduction on your income taxes, you can take maximum advantage of these retirement savings tax breaks.
But some investments are particularly attractive for these tax-advantaged plans. Putting dividend paying stocks in these plans allows dividends to compound without incurring taxes on each dividend payment. Avoiding immediate taxes on these dividend payments gives you more money to invest and increases the power of compounding over the decades of retirement savings.
Real estate investment trusts are another investment to consider putting in tax-advantaged accounts. In exchange for avoiding corporate taxation, REITs are required to pay out at least 90% of their income as dividends resulting in above average dividend yields. In a taxable account, REIT dividends are taxed as ordinary income and do not meet the criteria for the qualified dividend tax rate. However, REIT dividends are generally treated the same as any other dividend when put in a tax-advantaged account.
Whether or not a cap is put on tax-advantaged plans, you can still take maximum advantage of their tax benefits right now.
The bottom line
Tax-advantaged plans such as 401k plans are excellent ways to save for retirement as they can provide decades of tax-free compounding. Obama's proposal is far from some sort of government seizure action nor does it cap total savings for retirement.
Even at that, the proposal is unlikely to be implemented with both houses under Republican control and previous similar proposals failing to gain traction.
But regardless of whether this proposal is implemented, the vast majority of people saving for retirement can benefit from considering dividend paying stocks and REITs for their tax-advantaged retirement plan to get the biggest tax benefits possible.