Capping 401(k) Deferrals: A Path to Deficit Reduction or a Danger to Small Business Plans?

As I’ve cautioned in previous blog entries, retirement savings incentives may be a prime target for policymakers searching for ways to ferret out government revenue in the name of deficit reduction.

A Brookings Institution proposal that came out in late February would cap retirement savings-related deductions at 28%. In other words, this change would reduce the benefit associated with contributions to 401(k)s, IRAs and other qualified retirement accounts for the higher-income taxpayers whose tax rate exceeds 28%.

According to Brookings fellow Karen Dynan, who wrote the proposal (“Better Ways to Promote Saving through the Tax System”), wealthy investors would save for retirement anyway, even without taxpayer incentives.

A 28% limit on the tax benefit for high earners would reduce the budget deficit by about $7.5 billion in the first year, the proposal states. Combined with other recommended changes in Dynan’s plan, there would be a net reduction of about $4 billion a year, according to the proposal.

The American Society of Pension Professionals & Actuaries (ASPPA) promptly issued a statement blistering the proposed cap. The group noted that because the tax incentive for retirement savings is a deferral, not a permanent exclusion, the proposal would amount to “double taxation” of contributions to retirement savings plans for anyone with a marginal tax rate over 28%. “If the proposal went through, a small business owner in the 39.6% bracket would pay an 11.6% tax on contributions made to the 401(k) plan today, and pay tax again at the full rate when they retire,” explained Brian Graff, executive director and chief executive officer of ASPPA.

While the Brookings proposal acknowledges that individuals subject to this double taxation may decide to put their savings somewhere other than a 401(k) plan, it doesn’t investigate the potential ripple effects on small businesses, ASPPA noted. “What it fails to acknowledge is when that double-taxed person is a small business owner and it no longer makes sense for the owner to have a 401(k) plan, that owner probably won't offer a 401(k) plan to the employees, either,” said Graff. “You won’t expand coverage by penalizing small business owners for offering a 401(k) plan.”

My view

ASPPA’s point is well-taken. When you make it less desirable for small business owners to sponsor a plan, they will be more likely to discontinue it, thus cutting off the opportunity for their employees to save via a workplace plan. Retirement savings incentives are an important reason why 401(k) and other plans work for the benefit of both the employer and employees at all compensation levels. Encouraging retirement savings is a major public policy goal that should not be sacrificed in the name of short-term deficit reduction.

Any opinions expressed are solely the opinions of Jon Vogler and do not necessarily reflect the opinions of Invesco Distributors, Inc. or any of its affiliates. This information is not intended as tax advice. Please consult a tax advisor regarding individual situations.

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