As the government reaches for more revenue to avert the fiscal cliff, new limits on tax expenditures currently under discussion could have the effect of reducing potential 401(k) contributions by 65%.
That conclusion is a matter of arithmetic, though the numbers vary with a person’s income, according to Brett Goldstein (left), director of retirement planning for American Investment Planners, a Jericho, N.Y., financial advisory firm.
Under a proposal dubbed the 20-20 cap now under consideration, employees would be able to contribute the lesser of $20,000 or 20% of their pay, Goldstein told AdvisorOne in an interview.
An employee earning $50,000, for example, could contribute as much as $10,000–inclusive of the company match, which Goldstein says is typically 4%, or $2,000.
That means this employee could contribute just $8,000, or 54% less than the $17,500 that current law allows.
If that same employee were age 50 or older, the “catch-up” provision of the law currently allows him to save another $5,500, for a total of $23,000.
So the proposed cap on contributions would reduce the contributions of an employee over 50 earning $50,000 a year and aggressively saving for retirement by 65.21%, the advisor calculates.
The impact of such a cap would be felt even more severely by lower-income employees. An employee (under 50) earning $30,000 a year would be limited to $6,000 a year (20% of pay) minus the employer match.
Perhaps a more crushing blow to low-income employees is the likelihood, as Goldstein sees it, that small business owners, doctors, lawyers and accountants will just close their 401(k) plans.
Take the average business owner who makes $75,000 to $100,000. If the new cap takes effect, he’d be able to stash $15,000 or $20,000, respectively, minus any employer match.
“Why bother putting that in a 401(k),” Goldstein says. “That’s a reduction of $10,000. You can contribute to an IRA up to $6,500 and put the rest in an annuity. And you can save on administration costs and save on matching.”
Goldstein just terminated such an account, unrelated to the current talks in Washington. “We just closed out a plumbing distributor [client’s plan]. He had a defined benefit plan that was just a little too costly.”
But give a powerful disincentive to business owners to maintain such plans, and low-income employees will see perhaps their only source of retirement income aside from Social Security disappear.
Goldstein says there is a historical precedent for his pessimism about 401(k) contributions plunging. “The last time Congress slashed 401(k) contributions was in 1986. 401(k) contributions were cut by 70% and many 401(k)s were terminated,” he says, adding that “Congress should be encouraging Americans to save money for retirement, not making it more difficult for them.”
Goldstein’s firm’s response to pending changes is to advise clients to look to IRAs and annuities for their retirement income needs if the so-called 20-20 cap now on the negotiation table is approved.
“People are going to have to look for alternative methods of saving for retirement,” Goldstein says. “If [small business owners] don’t want [to continue] their retirement plans, IRA and annuities are the logical place to go. They’re the only other tax-deferred savings vehicles.”
Goldstein particularly recommends annuities with income riders.
“Most of the insurance companies are offering income options and those income options can range from 4 to 5%,” he says. “What that means is a client who puts in $100,000, that account would grow over time. Once they retire, they [are] guaranteed an income of 4 to 5% regardless of what happens with the market … over their lifetime or spouse’s lifetime.”
From a business point of view, Goldstein says the proposed change won’t affect his firm, which has an in-house third party administrator handling 401(k) accounts but also offers advises clients on IRAs and annuities.
“We’re just trying to service all of the client’s needs; it really doesn’t hurt our business,” he says.
Indeed, he says the policy changes may prompt useful advisor-client discussions. “Over the next few weeks, it’s an opportunity for advisors to get in front of people to discuss their needs–and just go over you [their] account one more time.”
But from a public policy point of view, Goldstein laments the financial mismanagement the changes reflect.
“The [reduced allowances] is money the government is not capable of living without anymore,” Goldstein says.
“We all have to live within our means, but apparently the government can’t live within theirs so they’re asking everybody else to pay for it,” he adds.
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