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The End of the 401k Plan as We Know it?

End of the 401k plan as we know it?
The End of the 401k Plan as We Know it?

It is common knowledge that Americans are reaching retirement in worse financial shape than the generation before. Countless articles decry the coming “American retirement crisis” and the litany of reasons for it. No matter why it occurs, the solution is simple: workers need to save more money during their working years. Ironically, a proposal by President-elect Joe Biden to revamp the retirement plan would likely encourage the opposite.

The Biden plan aims to make 401(k) and other company-sponsored retirement plans fairer. This may seem a worthy goal given that 94% of eligible employees earning more than $150,000 a year participated in 401(k) plans, while only 31% of those making less than $15,000 did, according to a Vanguard study. Even worse, Vanguard found that while the average 401(k) balance is $92,148, the median 401(k) balance is only $22,217.

The tax benefits offered by 401(k) plans are not evenly distributed either. For example, if you are an individual taxpayer earning $200,000 a year, you are likely in the 32% tax bracket. If you are under 50 and contribute the maximum $19,500 to your plan, you can defer paying taxes of $6,240. If you make $40,000 a year, and are in the 12% bracket, you can only defer taxes of $2,340 on the same $19,500 contribution. Clearly, those at the top of the income ladder are making the most of the tax-advantaged 401(k) structure, while those at the bottom are getting left behind.

But, will the Biden plan really fix this? The president-elect’s plan aims to eliminate the disparity in benefits by giving everyone who contributes to a 401(k) plan a 26% federal tax credit rather than a full tax deduction, even if you earn too little to pay taxes. The problem is that this likely won’t encourage lower-income earners to save more. Those in very high-income tax brackets often already do not participate in these plans. That means those in the middle, those saving the most for retirement already, who will see the greatest impact. And, that impact generally will not be favorable, causing many of these savers to reduce or eliminate their annual retirement savings.

In a 2015 research report, Financial Engines estimated that 25% of plan participants miss out on receiving a company’s full match because they do not save enough. Almost 42% of plan participants earning under $40,000 per year left money on the table by not taking full advantage of their employer’s matching contributions. Accordingly, it seems naïve to think that making the tax benefits of plan contributions fairer will encourage low wage earners to save more.

Additionally, the ultra-wealthy often have more options to defer and avoid taxes through business interests and private investments. Given the annual limits on 401(k) contributions, $19,500 for 2020, the tax benefits to participating in employer-sponsored plans are insignificant for someone making $2 million or more annually. Thus, any change in tax rules will likely not impact this group.

However, middle-income earners who are currently maxing out their 401(k) contributions may be disincentivized from saving through these plans in the future. The tradeoff with 401(k) plans is that you avoid taxes now but pay them in the future when you may be in a lower tax bracket. But that often is not the case. Some people do not ever retire. Some continue to have high incomes after retirement because of pensions, required minimum distributions, or other investment income. Or it may be the case that tax rates rise for everyone in the future. In these circumstances, it won’t make sense to save in a 401(k) plan. Why defer taxes today only to pay more later? So, if your income would qualify you for a 32% tax break, but the government limits you to 26%, many more savers will do the math and realize saving in traditional retirement plans incurs a penalty rather than a benefit.

Additionally, the proposed plan ignores safeguards already in place to ensure fairness. The Employee Retirement Income Security Act (ERISA) requires employers to undergo 401(k) discrimination testing annually. It ensures that businesses comply with enacted federal requirements and regulations, making sure that plans are being used equally and not providing matching contributions to just highly compensated employees.

The government also already equalizes benefits by requiring minimum distributions after age 72. Those distributions are taxed as ordinary income. So, for those who have saved large amounts in their retirement plan, they will end up losing much of that perceived benefit because they will be in a relatively higher tax bracket when taking distributions.
One solution for those most impacted by this plan would be to shift savings to a Roth 401(k). However, not all 401(k) plans offer this option. Even for plans that offer Roths, much education will be required to encourage active participation if the media, rumor mill, or employee discussions suggest that 401(k) plans no longer make sense.

The proposed Biden plan’s interpretation of the cause of our retirement crisis is that middle- and higher-income earners, and those who diligently participate in saving for retirement, are receiving an unfair and outsized benefit to do so. As a result, they should be punished and disincentivized to save, while those who have elected not to participate, or those who earn less, should be subsidized by taxpayers. One could argue that we already have a government-controlled retirement program that does something very similar, called Social Security.

It’s hard to see how the Biden plan will have a positive meaningful impact on addressing the core issues behind the American retirement crisis. The likely net effects are that middle- and higher-income workers will be punished and stop saving so much, making the looming retirement crisis even worse.