Washington Contemplates Severe Cap on 401(k) Contributions

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A proposal to impose a “20/20 cap”—the lower of 20% of income or $20,000—on contributions to 401(k)s and other defined contribution plans is making rounds in Washington. Most Americans appreciate the need for Congress to pull out the stops to bridge the budget gap, but do we really want to discourage retirement savings as Social Security continues its inexorable slide toward insolvency?

The National Commission on Fiscal Responsibility and Reform—charged by President Barack Obama with “identifying policies to improve the fiscal situation in the medium term and to achieve fiscal sustainability over the long run”—is calling for the 20/20 cap to replace the current dollar limit imposed on contributions to most accounts. The commission’s proposal would cap aggregate contributions to defined contribution plans to the lower of $20,000 or 20% of income—employer and employee contributions combined.

The proposal also would collapse all defined contribution plans into a single investment vehicle for all employers.

The limit would significantly reduce the overall limit on contributions to defined contribution plans, as the current limit on aggregate employee/employer contributions is the lesser of $49,000/year and 100% of an employee’s compensation.

One small subset of savers would benefit from the proposed “limit,” but overall it would hurt retirement savings. The limit on contributions to a traditional 401(k) for 2011 is $16,500. So for individuals earning $82,501 or higher per year who do not contribute to any other type of defined contribution plan and whose employer does not contribute to their 401(k), the new limits would increase their  401(k) contribution limit by up to $3,500. For everyone else, the new limit would drastically reduce the amount they can contribute to their retirement future.

According to a recent study conducted by the Employee Benefit Research Institute, although the 20/20 cap would hurt the retirement prospects of most workers, it would result in a disproportionate reduction in retirement plan balances for the highest and lowest income workers.

It would hurt the highest earners most, but would also “cause a very big reduction in projected retirement accumulations for the lowest-income workers.” And these reductions would come at a time when almost half of Baby Boomers and Gen Xers are “at risk” of their retirement savings drying up before the end of their lives.

Some believe the cap only eliminates defined contribution plans as "a vehicle for wealthy individuals to convert a substantial share of their assets into tax-free retirement assets," (Bipartisan Policy Center), but the cap would also hurt those who need personal retirement savings the most. And despite the obvious need for belt-tightening in Washington, there’s plenty of other fat to trim that won’t hurt Americans’ retirement prospects.

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