Will Republican Tax Cuts Mean Lower Limit On 401(k) Contributions?

Some people with 401(k) retirement plans will put as much money into it as they can, but there are whispers that the tax cuts being drafted by Republicans in Congress could reduce the maximum amount of money you contribute to your retirement savings each year.

The Wall Street Journal reports today that among the many plans being considered on Capitol Hill is one that could leave a lot of hurt in its wake in the long term.

Retirement is complicated… and expensive

Obviously, the exact amount an individual is supposed to save in order to retire comfortably varies widely. Some parts of the country have drastically higher costs of living than others, just for starters; the variables are seemingly endless, and the math gets complicated.

As a general rule of thumb, retirement planners calculate based that you’ll want to replace 80% of your income from retirement until death. So if you retire at 65 and live to 90, you’ll need 80% of your income at age 64 for 25 years.

The U.S. median household income in 2016 was $59,039 — we can round that off to $59,000, for our purposes. That means someone who retires at that income level would need $47,200 per year to live on for 25 years, a total of about $1.18 million.

Now granted — not all of that has to come from money socked away over the previous 40 years of employment. Some will come from returns on investment, in a plan like a 401(k), and some will probably come from Social Security.

Still, by age 30, experts recommend you have retirement savings equivalent to about one year’s pay. By age 40, that increases to 3 times your annual pay (which, ideally, is also higher for you at 40 than it was at 30), and up to 10 times your annual pay by the time you retire. For that median income household, then, that’s at least $590,000.

The current cap on 401(k) contributions is $18,000 per year for workers under 50 and $24,000 for workers over 50, so under the current rules someone who works from age 25 to 65 could put a theoretical maximum of $810,000 a single 401(k) account. (Those limits are set to rise by $500 each in 2018.)

That’s a lot of math, but so far fairly straightforward: Experts guesstimate your retirement will cost seven figures, and you can currently contribute most of it to your 401(k) yourself in theory, not even accounting for employer matches or returns.

If 401(k) contributions were to be capped at $2,400, though, then the maximum a person could contribute to it for the 40 years between ages 25 and 65 would be $96,000.

That’s $200 per month, or about 4% of the gross pay our median household brings in… when experts recommend saving 10% – 20%. In other words, it’s a bare fraction of what you need.

So… why?

The thing that makes 401(k) accounts popular is that they’re tax-deferred. If you make $50,000 this year, but put $5,000 into a 401(k), then when it comes time to do your taxes that $5,000 doesn’t count, and your taxable income drops to $45,000. That means you probably get a fatter refund back (or owe less), and most people like that.

Instead, you pay your taxes on the back end: When you withdraw the funds in retirement, you pay income tax on that money. The benefit there, though, is that you’re probably in a lower tax bracket at that point in life than you were when you were working and saved it up, and so you still come out ahead in the long run.

And there’s the bind. Republicans in Congress want to pass a tax cut. That’s kind of their thing. But taxes fund things; the government uses the money.

Some of the shortfall can be made up in spending cuts, which the White House has already suggested, but some of it needs to be revenue that comes from other sources, too.

So there’s the reasoning behind the math: Congress can cut your tax rate, but — by limiting 401(k) contributions — increase your taxable income at the same time, thus limiting the damage to revenue from a tax cut.

Not exactly popular

Slashing the maximum limit for 401(k) contributions is unlikely to be warmly greeted by pretty much anyone.

Investment firms, and the lobbyists and trade groups that represent them, are concerned about the idea, the WSJ says — and that makes sense. If fewer people are investing money with them, and the ones who are are investing less, that’s bad news for the companies that make money from the funds.

Some members of Congress aren’t so sure this is a good idea, either.

Ohio Senator Rob Portman told the WSJ that he was “skeptical” about the proposal, adding, “I don’t think you want to disincentivize retirement savings in any way right now.”

Indeed, recent surveys find that between one third and one half of all American households have literally no retirement savings at all.

The House Ways and Means Committee is expected to release a version of the tax bill by mid-November, the WSJ reports. After that, given how Congress has operated this year, it’s anyone’s guess what happens next.