Memo to Congress: Make this Change to 401(k) Accounts NOW!
By Ric Edelman
Retirement plan tax rules have become terribly outdated, and should be changed for the benefit of American workers. To understand why, we must return to the origins of retirement planning in the United States.
Today, most workers who have a retirement plan at work have a 401(k). What many do not realize is that this is a relatively recent phenomenon; prior to the mid-1980s, most employees were instead covered by pensions.
Under the pension system, your employer sets aside money for you. When you retire, the company sends you a monthly check, for as long as you live. (Social Security is the ultimate pension plan.)
Throughout most of the 20th Century, workers entered retirement with “a gold watch, Social Security and a pension” and because of this, they gave retirement little attention. After all, there was no need: Not only were relatively few going to live long enough to reach retirement age, their employers took care of everything. The Companies were the sole contributors to the accounts, and they handled the investment and management of the pensions, and issued the checks to the retirees (and, sometimes, to their surviving spouses). Although, some workers today are still eligible to receive a pension, they represent a small portion of the overall workforce, a portion that is steadily shrinking. (Pension income, by the way, is taxable income when it is received by the retiree.)
Companies dislike pensions for two main reasons. First, as a big company watches more and more of its employees retire, it must pay pension benefits to an ever-larger group of people, and those retirees are living much longer than anyone in the 1950s envisioned. These demographic shifts have created severe financial burdens for many large companies. More than a few have gone bankrupt as a result of it...and when a company goes broke, its retirees could lose their pensions.
The second reason is “fiduciary liability.” It means that the employer, who is managing the pension assets for the employees, is legally responsible for managing those assets effectively. If the investments fail to perform satisfactorily, workers can sue their employer – and this has happened often enough.
This is why 401(k) plans became so popular with employers. Instead of promising to pay workers a certain benefit at retirement, companies merely contribute money into an account on the employee’s behalf; the employer has no further financial obligation to the employee. By letting the employee decide how to invest the money, the employer is free of fiduciary liability, too (provided it meets certain requirements, such as offering its employees a sufficient number of investment choices).
And to make 401(k) plans popular among workers, Congress allows workers to contribute a portion of their own paychecks into the plan, to boost its eventual value at retirement. This is crucial, because for most U.S. workers, the 401(k) account has replaced their pension. Whereas their employers once provided them with a retirement income, workers now must provide their own. (Without question, the amount that employers contribute is not enough to meet the need and at many companies, employers contribute nothing to the account; employee contributions are the sole source of funding.)
Despite this rather radical shift — the burden for securing sufficient retirement income from employer to employee – the tax rules have not changed: When a worker withdraws money from the 401(k), the income is taxed, just as pension income was taxed, and just as ordinary income is taxed.
When 401(k) plans were introduced to workers in the 1970s and early 1980s, nobody cared. In fact, those who paid close attention were thrilled with this arrangement. Why? Because of something then known as “bracket creep.”
You see, under the tax law of the 1970s, tax rates ranged from 14% to 70% — compared to the lower rates of today’s law. As a result, a person in 1975, who earned slightly more income than before, found herself in a higher tax bracket. Since the top rate was 70%, workers quickly discovered that making an extra dollar could cost them as much as 70 cents in taxes, depending on the tax rate. Thus, for many workers, making more money was pointless. In fact, people routinely sought ways to lower their incomes (which is why all those tax shelter games were so popular in the 1970s and 1980s).
So, when Congress gave workers the opportunity to place some of their income into 401(k) plans, workers jumped at the chance. After all, if they took the pay now, they’d lose a lot of it to taxes. But by placing the money into the plan, they avoided the current tax. And since their income would be much lower in retirement, their tax would be lower, too. Thus, the popular mantra that it makes sense to invest in tax-deferred savings via 401(k) plans and IRAs and the like; because you “defer the tax to a future, lower tax bracket.” This was entirely true, and it was smart tax planning. Back then planners spent most of their time counseling clients on tax-motivated investment strategies, because the primary goal was to reduce current income, which lowered current taxes. And with a 70% top tax bracket, that was worth doing.
In fact, deferring income, and the taxes that went along with it, was so worthwhile that few people cared where the deferred money was invested. After all, if deferring income was expected to cut your taxes from 70% to 14%, then you produced a 56% profit – even before the money was invested! Thus, the investment became a detail – and a relatively unimportant one at that.
But let’s fast-forward to today. Under today’s tax law, bracket creep is a thing of the past. For the vast majority of taxpayers – probably including you — no matter what tax bracket you’re in today (10%, 15%, 25%, 28%, 33% or 35%) you are likely to remain in that bracket for the rest of your life – including (yes) your retirement years. Therefore, tax deferral no longer lets you pay future taxes at a lower rate than you’d pay today. Instead, you merely get to pay later (and that does remain a planning goal, for paying later is always better than paying now).
In fact, thanks to the way the current tax law works, it’s likely that you’ll actually pay a higher rate later than you pay now! How can this be?
Simple: If you invest a portion of your paycheck, those investments eventually will be taxed at capital gains tax rates. The maximum capital gains rate is 15%, and for many workers, it’s just 5%. But if you move some of your pay into the 401(k) and invest it inside the plan, you will be taxed the same way as workers were back in the 1970s: at ordinary tax rates. Today, the top rate is 35% — or more than double the top capital gains rate. Thus, many workers could find themselves deferring their income to a future higher tax, instead of a future lower tax like their parents and grandparents.
This is inherently unfair. It is also an accident, for when Congress changed the tax rates in 1986, it was not trying to create this problem. So, it’s an unintended side-effect of tax reform. Regardless, it must be changed. After all, the investment you buy with your 401(k) assets is the same investment you buy with money outside the plan. Why should one account let you pay a 15% tax, while the other forces you to pay a tax that is perhaps twice as high? Simply stated, this does not make sense.
I am not suggesting that you discontinue participating in your 401(k). The 401(k) plan remains the best way to invest for your retirement. Instead, I am calling on Congress to change the way 401(k) plans — and all other retirement accounts, including 403(b), 457, the Thrift Savings Plan and IRAs — are taxed. Retirement plan assets should be taxed at the same capital gains rates as other investment accounts.