With the election behind us, it is time for your clients to turn their attention to the looming tax reforms that should take shape over the next two months, and how these reforms can affect their retirement planning. Both arms of Congress will be working to reach a compromise on tax code provisions as basic as income tax rates before Jan. 1, after which the Bush-era tax cuts will expire, and rates could revert to pre-2001 levels.
Though President Obama spent little time discussing his views on tax-favored retirement accounts during his campaign, the plans he did set forth are indicative of the consequences for retirement savings. While this impact may not be immediately apparent to your clients, it is something that they need to consider as they plan for retirement this year and beyond.
Income tax rates
Under President Obama’s plan, income tax rates will not change for clients earning less than $250,000 per year, but clients earning more than this should expect a tax hike. The current proposals would increase the tax rate for clients in today’s 35% bracket to 39.6%. While this has an obvious impact on your clients’ take-home income, it also affects the value of their retirement savings accounts.
To illustrate with a simplified example, let’s assume a client in today’s 35% bracket contributes the maximum $17,000 in tax-free contribution to his 401(k) in 2012. Assuming a conservative 3% growth rate, the client’s $17,000 will have grown to $22,847 in ten years. If he would have invested the after-tax funds ($11,050 after 35% is withheld for taxes in 2012) over ten years, the balance would have grown only to $14,850 at a 3% growth rate.
If Obama’s plan is enacted, this client could pay ordinary income taxes at a 39.6% rate when he withdraws the funds. Assuming a lump-sum withdrawal after ten years, this will leave the client with $13,799. If the tax rate would have remained at 35%, the client would have been left with over $1,000 more—$14,850.
In this scenario, the client would be better off investing his 2012 funds outside of the plan so that the funds are taxed at 2012 income tax rates. Unfortunately, increased taxes on investments proposed for 2013 will also likely impact the higher-income client’s savings plans, so it is important to prepare clients for this reality if they are unable to invest in an account that provides for future tax-free withdrawals, such as a Roth IRA or Roth 401(k).
It should be noted that this scenario makes many assumptions: a 3% growth rate may be conservative, but if the markets have taught us anything in the past decade, the potential for variance is wide. Further, it assumes that the client will remain in the higher tax brackets after he has retired, which is not always the case.
It is also possible that we will see reductions in the maximum tax-deferred contribution limits for retirement savings plans in the coming years. While President Obama’s proposals do not spell out this possibility, his plan is to impose the larger tax hikes on higher earning clients in an effort to maintain today’s tax rates for lower- and middle-class families. Logically, high-income families are able to contribute the most to tax-deferred retirement accounts, putting the higher limits at risk.
Today, total employee and employer-matching contributions must be below $50,000 per year (the employee contribution limit is $17,000 in 2012). Proposals have sought to limit this amount to the lesser of $20,000 or 20% of the employee’s compensation, which could further reduce the value of your clients’ 401(k) accounts.
Though the parameters of the upcoming tax reforms are by no means set in stone, President Obama’s reelection gives advisors a slightly clearer picture of what to expect. Many of your clients have been preparing for this during the past year, but it is important that they be made aware of some of the less obvious effects that we could see.