The annual limit on tax-advantaged contributions to an employer sponsored plan 401(k) (assuming you are under age 50) is $18,000 in 2017. This limit is unlikely to go down as a result of the Republican tax proposal, despite what you may read about a drop to $2,400.
That's because the $18,000 is comprised of two types of contributions - regular pre-tax 401(k) contributions and so-called "Roth" after-tax contributions to a 401(k) plan. Under current law, you decide how much of the $18,000 limit you contribute to regular pre-tax 401(k) and how much you contribute to a Roth 401(k). Many employers have not made the Roth after-tax feature available to their employees, so many people, even financial writers seem to be unaware of it.
The author of this Washington Post article seems to be unaware of the distinction, not even mentioning Roth.
Don't confuse the "Roth" 401(k) that an employer sponsors with the "Roth" IRA that has been around a lot longer. You set up your own Roth IRA, not your employer and the dollar limit on contributions to a Roth IRA is only $5,500.
So, back to the tax proposal - it's really just a matter of Uncle Sam saying "Pay me now or pay me later."
There are important differences, which we's get to, but some people will be better off with the change.
If your tax rate when you retire is the same as the tax rate in the year that you saved, then there is no difference between the pre-tax 401(k) and a Roth 401(k).
For example, suppose I want to set aside $1,000 today in a pre-tax 401(k) account that earns interest for 15 years at 6% per year and my tax rate is 20%. My $1,000 account would grow to $2,400. After paying taxes of $480, I would have $1,920 left to spend after withdrawal.
Now suppose instead that instead of putting all of that $1,000 in a regular pre-tax 401(k), I pay taxes at 20% today on that $1,000 which leaves me with $800 after taxes to put in a Roth. What happens? You guessed it - the $800 in the Roth account grows at the same 6% per year to $1,920 which is tax free.
For a lot of people, the Republican tax proposal has no impact on retirement saving!
But the real story is more complicated.
If you expect your tax rates to be lower in retirement, then you are better off in the pre-tax 401(k), not the Roth. If tax rates increase for everybody due to future tax law changes, then now is a good time to save more in the Roth.
And there is one more impact no one seems to talk about. Those who are financially well off and looking for an upper hand on taxes are better off with the Roth. Why? Suppose a wealthy individual is in a 35% tax bracket both this year and in retirement and saves $18,000 in a pretax 401(k) account that grows to $100,000 at retirement, is withdrawn and taxed at 35%, leaving $65,000 in spending money.
That same person could set aside $27,700 of salary today by paying taxes of $9,700 (35% of $27,700) and put the remaining $18,000 in a Roth 401(k) that grows to $100,000 at retirement in the same year as the previous example - but pay no taxes on the $100,000!
So, for anyone who is hitting the tax law limits on saving, changing to a Roth contribution has the same impact as increasing the tax law limits.
None of this highly technical analysis touches on the real life impact that could discourage saving by lower paid workers if this $2,400 limit is made law. But that story is more complicated than it sounds. Most 401(k) plans have automatic enrollment features these days. Low paid employees contributing by automatic enrollment to a 401(k) are not likely to change their minds and take action to stop making Roth contributions. And they might even end up contributing more effectively for retirement if they have saved the same dollar amount after tax that they would have pre-tax, but their Roth account is not taxed when it is withdrawn at retirement.
That's the story from the worker's perspective. If you are well off, this change is not necessarily bad. If you are low paid, it's probably not bad because automatic enrollment will keep you saving for retirement. But from the perspective of the country, this proposal increases tax revenues today by removing future sources of tax revenue. This is yet another Republican tax policy slight of hand - eliminate the estate tax and reduce corporate taxes, offset those tax revenue reductions with a measure that increases current tax receipts, but blow up the deficit in the future. Let's forget about tomorrow cuz tomorrow never comes.
Ironically, DJT may have been told something about the 401(k) proposal that prompted the Oct. 23 tweet
"There will be NO change to your 401(k). This has always been a great and popular middle class tax break that works, and it stays!"
As tweets go, that may not be far off the mark. But we will never know, will we?
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