4 Reasons 401(k) Tax Reform Could Decimate the Middle Class

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It's no secret, so let's just say it: We absolutely stink at saving money. Among developed countries, Americans have one of the lowest personal saving rates. According to the St. Louis Federal Reserve, as of July 2017, Americans were socking away just 3.5% of their disposable income, or $3.50 out of every $100 they earned, which is well below the 10% to 15% of earned income that financial advisors recommend workers put away for retirement and an emergency fund.

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Saving such a small amount of their paychecks is leaving far too many people reliant on Social Security, which is struggling with its own issues at the moment, and it requires that workers invest flawlessly in order to have a sizable nest egg come retirement. The retirement path we're on as a country right now simply isn't sustainable -- and it could get worse.

Individual and corporate tax reforms come into view

During his election campaign, President Donald Trump promised the nation sweeping tax reforms, including a simplification of the individual U.S. tax code, as well as a lowering of the corporate income-tax rate. At a peak marginal tax of 35%, U.S. corporations are paying one of the highest income-tax rates in the world, which Trump believes is putting these companies (and the U.S. in general) at a distinct disadvantage. Trump has reiterated multiple times since becoming president, and during his campaign, that he would ideally like to see Congress pass a tax reform bill to lower the peak corporate income-tax rate to just 15%.

But there's a catch to putting more money into the pockets of corporations, which Trump and Republicans believe will boost the U.S. economic growth rate, lead to more hiring, and increase wages. Namely, it'll take about $2 trillion in federal revenue off the table over the next decade, at least according to estimates from the Tax Foundation, a nonpartisan research institute. In order for Trump's tax reforms to be revenue-neutral over the decade, he'd need to find a way to increase federal revenue by $2 billion.

One way Trump and his GOP colleagues are aiming to do this is by cost-cutting. Trimming the fat in Washington, and potentially reforming healthcare by cutting Medicaid spending substantially over the next decade, could markedly reduce the expected $2 trillion shortfall from cutting corporate income-tax rates.

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Republicans are considering a big change to America's top saving tool

But cost-cutting alone wouldn't be enough, which is why the highly unpopular idea of making changes to the employer-sponsored 401(k) has crept into view. As of March 2017, 55 million workers had more than $5 trillion invested in 401(k)s, making it the top saving tool among working Americans. 

The idea being floated around Capitol Hill is that lawmakers want to alter the tax treatment of 401(k)s, which are currently tax-deferred plans. In other words, money currently contributed to a 401(k) is considered pre-tax -- thus lowering your current-year tax liability -- and allowed to grow on a tax-deferred basis until you begin making withdrawals. Ordinary federal income tax becomes due when account holders begin taking money out of the 401(k).

Lawmakers are considering a change to make contributions to 401(k)s after-tax, thus taxing contributions up front and allowing account holders to take withdrawals on a tax-free basis when they retire. If this sounds familiar, it's because this is what a Roth IRA does (after-tax money growing over the long term on a tax-free basis). Pundits have suggested that this plan would "Rothify" the 401(k), giving the federal government more money up front to help cover its corporate-tax cuts.

However, such a move could be devastating to the middle class.

401(k) tax reform could crush the middle class

Arguably the biggest issue with 401(k) tax reform is that it could discourage saving among workers, which as noted is already at exceptionally low levels compared to other developed countries. This isn't to say that a growing number of companies aren't offering Roth 401(k)s, which are funded with after-tax dollars and allow for tax-free retirement-age withdrawals, just like a Roth IRA. But it's pretty evident from the data that workers prefer a traditional 401(k) compared to the Roth 401(k), since a traditional 401(k) provides for a greater up-front investment since it's not taxed.

Secondly, altering how 401(k)s are treated for tax purposes could reduce what companies are matching for their employees. Under a traditional 401(k), company matches are considered pre-tax contributions, thus avoiding federal taxation until workers begin making withdrawals. Under the Republican proposal, matching contributions would presumably be considered after-tax dollars, resulting in a lower up-front match. It may also discourage employers from offering a high match, especially if their workers opt for a Roth IRA instead of an employer-sponsored 401(k). That's not such a bad thing for employers, as they could retain more of their cash flow, but it'd wind up costing working Americans who rely on their company match to boost their nest egg.

Thirdly, the "Rothification" of the 401(k) could actually hurt middle-class and well-to-do workers by removing a critical retirement option. For example, the 401(k) is often a smarter choice for workers if they'll be in a lower tax bracket once they retire. After all, if you have to pay tax on your withdrawals, you want to pay as low a rate as possible. Conversely, a Roth IRA is a smart tool for workers who expect to be in a higher tax bracket during retirement, since a Roth IRA allows for tax-free withdrawals. If you're among the middle- or upper-income class and expect your tax bracket to drop during retirement, being forced into a system with an up-front tax and a tax-free withdrawal during retirement isn't favorable for you, and it'll likely result in a smaller nest egg overall.

Lastly, the change being suggested to the 401(k) would be only a temporary solution. Though it would boost near-term revenue, potentially allowing the federal government to pass along its desired tax cuts, it would presumably leave Uncle Sam short of tax revenue in the generations to come. While that's a problem that lawmakers suggest they can deal with later, it looks like the perfect scenario to raise taxes and extract even more income out of the middle class and well-to-do in the decades to come.

It's important to understand that 401(k) tax reforms are merely chatter and not officially in any tax reform bill at the moment, so don't overreact to the rumors. Nevertheless, it's important to pay close attention to what the GOP plans to do to raise additional revenue in lieu of corporate income-tax cuts, because your retirement may depend on it.

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