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Deficit Tax Proposals Would Radically Change 401(k)s: EBRI

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If enacted, two major tax-reform proposals aimed at shrinking the federal deficit would reduce 401(k) plan contributions and likely send retirement account balances tumbling, according to a new analytic report by the nonpartisan Employee Benefit Research Institute, based in Washington, D.C.

Both proposals, which would change current tax policy toward retirement savings, could pop up in the plan due Nov. 23 from the congressional supercommittee. That 12-member bipartisan panel has a mission–impossible?–to produce legislation to cut $1.2 trillion from the federal deficit over the next 10 years.

“Something has to be done about the deficit, and 401(k)s are a very major source of tax preferences right now,” said Jack VanDerhei, EBRI’s research director and author of the report, “Tax Reform Options: Promoting Retirement Security,”  in an interview with AdvisorOne.

Defined contribution plans, such as 401(k)s and the IRA rollovers they enable, are the “component of retirement security that seems to be generating the most non-Social Security retirement wealth” for baby boomers and Generation-Xers, according to VanDerhei.

But in an EBRI survey conducted in January 2011, one out of four employees said they would reduce their 401(k) contributions if they could not deduct them, which is precisely what one of the proposals would require.

This would exacerbate the problem cited in a 2010 EBRI study that almost half of baby boomers and Gen-Xers would be at risk for not having enough retirement income to cover even basic expenses and uninsured health care costs.

One of the proposals, from the Brookings Institution, of Washington, presented at a Senate Finance Committee hearing this past September, would take away the employee tax deduction for 401(k) contributors and at the same time subject employer contributions to current tax. Promising to offer $450 billion in savings over the decade, the proposal would replace existing tax deductions for 401(k) contributions with a flat-rate refundable credit serving as a matching contribution.

For example, under the current system, an employee with income of $60,000 who contributes $10,000 and whose employer matches that with $5,000, has their taxable income reduced to $50,000. Further, the employer’s $5,000 is not taxed. Under the proposal, the employee would pay taxes on the entire $60,000, with the employer’s $5,000 matching contribution counted as taxable income, too, making total taxable income $65,000.

“As a quid pro quo, the government would provide an 18 percent match, under the most recent version of the proposal,” VanDerhei said. But “you’re not only getting taxed going in but coming out too. That’s double taxation.”

If the proposal is enacted, he said, “every single financial advisor would have to seriously consider the tax ramifications of recommending something with double taxation. They’d need to tell clients: ‘We now have to figure out whether or not it makes sense for you to contribute to a 401(k) plan.’ ”

The other proposal, dubbed the “20/20 Cap,” would substantially reduce the current limits under qualified defined contribution plans. It was introduced in a December 2010 report, “The Moment of Truth,” from the National Commission on Fiscal Responsibility and Reform and would limit individual annual contributions to either $20,000 or 20 percent of income.

If enacted, VanDerhei said FAs might well be advising clients: “Because now you can’t put as much in your 401(k) plan as you could before, we have to start considering other saving options over and above it.”

An ERBI analysis of hypothetical enactment of the 20/20 Cap starting in 2012 found, not surprisingly, that it would most affect those with high income. The highest income group showed the largest average percentage reduction in 401(k) account balances, ranging from 15.1 percent for the highest income group for ages 36-45 to 8.6 percent for the highest income group ages 56-65.

EBRI is now surveying 401(k) sponsors on the two proposals.

“Even though the survey isn’t finalized, I can tell you that what Brookings asserted–that plan sponsors and employees would not react negatively and change their behavior–certainly would not be true,” VanDerhei said.

On Friday the results of a survey conducted by Principal Financial Group are expected to be released, according to VanDerhei, that will “strongly confirm” EBRIs findings that both employees and plan sponsors would have “very, very strong negative response” to the above proposed changes.

What’s ahead? “I can virtually guarantee,” said the research director, “that the whole concept of tax preferences will be re-examined in 2012 and 2013.”

The nonprofit EBRI, established in 1978, studies retirement and health plans to encourage development of fair employee benefit programs and sound public policy.