Why Cutting Pre-Tax 401k Contributions May Be Good (Wait …What?)

President Trump had promised no change to 401ks and Republican lawmakers in the House appear to have agreed. The tax reform proposal they shared leaves 401k plans alone—at least for the moment.

Lawmakers had considered a cap of $2,400 on pre-tax 401k contributions. Any additional contributions participants would have been allowed to make would have been of the Roth 401k variety — after-tax.

The New York Times reports that the federal government loses $115 billion per year in tax revenue due to pre-tax contributions. The tax cut being considered, according to the Times, is $1.5 trillion over 10 years. If my math is right, the federal government would appear to be looking for $150 billion a year to fund the tax cut. Limiting pre-tax contributions would seem to plug a pretty big part of that hole.

Adding to the discussion, Republican lawmakers in the House had indicated that their proposal would raise the amount that Americans could contribute to their 401k plans.

Presumably, this would have occurred via a higher contribution limit for Roth 401k contributions. Unfortunately, the proposal that was released does not seem to allow for higher contributions of any kind.

What should lawmakers do? I hope they consider the following:

Limit pre-tax 401k contributions if you must

Without arguing the social worthiness of tax cuts (excuse me, tax reform), let’s just all agree to assume that it will happen.

The big question then is: Would 401k plan participants be disadvantaged as a result of a much lower cap on pre-tax 401k contributions? The answer, likely, is no. Here is why.

With a tax cut imminent, and deficits expected to rise as a result, does anyone believe that tax rates will be lower 10, 20 or 30 years from now? I sure don’t. So, if you had to choose whether to have your 401k contributions taxed now, or later when you retire (at higher rates), wouldn’t you choose now? That would seem to argue for making Roth 401k contributions now versus pre-tax contributions. That is just what most savers would end up doing if the 401k pre-tax limit was lowered.

Savers may actually contribute more

A major concern of many experts is that a lower pre-tax 401k contribution cap would discourage many savers from contributing to 401k plans. I don’t think that is likely. In fact, I believe most participants may actually end up contributing more. Here’s how.

The Wall Street Journal recently shared the results of a Harvard Business School study that answered the question about which form of contributions is better for 401k participants. Surprisingly, the answer was Roth 401k. But probably not for any reason you might guess.

Researchers found that when participants switched from making 401k pre-tax contributions to Roth 401k contributions, they tended to contribute the same percentage amount. This means that they are actually contributing more when making Roth 401k contributions because savers are paying taxes on those contributions.

So, at retirement, the net amount available for participants will be higher in an account funded by Roth 401k contributions (taxes already paid) as compared with a pre-tax 401k account (taxes due, probably at higher rates) assuming the same contribution rate.

What lawmakers should do

Allow Americans to contribute more toward their retirement via any means available. We have a retirement savings crisis in this country. I believe any retirement expert would agree with that. Too many Americans have little or nothing saved for their retirement.

I can tell you from talking with participants for more than 30 years that the most prevalent strategy that lower-income Americans have to counter their lack of retirement savings is to work longer. And we know that for many Americans, for many reasons, that just won’t be an option.

There are so many different and worthy ideas on how to allow Americans to contribute more that I will not attempt to list all of them here. But I would like to share three suggestions.

1. Allow a much higher cap on Roth 401k contributions. For those Americans who haven’t contributed enough in their early years, this will provide a way to catch up. For 2018 total 401k contributions (both pre-tax and Roth after-tax) are limited to $18,500 plus $6,000 for those participants age 50 and older. Why not allow Roth 401k contributions up to $30,000 or $40,000? There is no loss of tax revenue now when Roth 401k contributions are made.
2. Raise the contribution limit on Health Savings Accounts (HSAs) to help Americans pay for health care in retirement. Healthcare in this country is expensive. And it doesn’t get any cheaper in retirement. HSA contributions are triple tax-free and can be used to pay for many different types of healthcare expenses, while working and in retirement. But the contribution limits now are too low, $3,450 for an individual and $6,900 for a family for 2018. As a result, there is no way these accounts can be used as retirement savings vehicles.
3. Finally, to help the significant numbers of working Americans who do not have access to a retirement plan, raise the cap on Roth IRA contributions as well. For 2018, tax-deductible plus Roth IRA contributions are limited to $5,500 for those workers under age 50 and $6,500 for those age 50 and older. Why not at least double the cap? Again, no loss in tax revenue right now.

We have a retirement savings crisis and a health care crisis in this country. It’s not too late for lawmakers to use tax reform now to make progress toward solutions for both.

Robert C. Lawton, AIF, CRPS is the founder and President of Lawton Retirement Plan Consultants, LLC. Lawton is an award-winning 401k investment adviser with over 30 years of experience. Lawton Retirement Plan Consultants, LLC is a Milwaukee, Wisconsin-based independent, objective Registered Investment Adviser (RIA) providing investment advisory, fiduciary compliance, employee education, provider management and plan design services to 401k plan sponsors. For more information, please contact Robert C. Lawton at (414) 828-4015 or bob@lawtonrpc.com.