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The GOP's 401(k) ideas raise a big question

401(k)s and new jobs
What to do with your 401(k) before your next job 02:49

Will the Republican Congress reduce or eliminate current tax deductions for 401(k) plans by reframing them as Roth contributions? That's the subject of current intense debate and speculation among analysts, lawmakers and the media. Earlier this week, President Donald Trump tweeted that such changes are off limits.

But not so fast. The Republican congressman who leads the House tax-writing panel, Kevin Brady, isn't ruling out such changes to 401(k) plans, and subsequent statements by Mr. Trump appear to be walking back his earlier statement, muddying the already unclear waters. Other Republican lawmakers appear to support the idea of finding more tax revenues to offset projected revenue reductions due to their proposed tax cuts.

Let's be clear: Reducing or eliminating the deduction for 401(k) contributions from taxable income could be a tax increase for many middle-income workers, all other things being equal. That's because many middle-income workers are in a higher tax bracket when they contribute to their 401(k) plan (and take the deduction) compared to when they withdraw from their accounts during their retirement years, making these withdrawals subject to taxation.

Many middle-income workers will see a drop in their marginal income tax rate during their retirement, compared to their working years, for three reasons:

  • Even when you add up Social Security benefits and modest levels of income from pensions and savings, most middle-income workers will still be making less total taxable income when they retire.
  • Part or all Social Security income is exempt from federal income taxes for all retirees, including middle-income workers. For many middle-income retirees, half or more of Social Security income will be exempt from federal income taxes, and for most of them, Social Security will be the largest chunk of their total retirement income.  
  • Taxpayers age 65 and older enjoy a higher standard deduction.

For example, to address this last point, workers who currently pay taxes at the 25 percent marginal rate will most likely drop to the 10 percent or 15 percent bracket in retirement, and some retirees will pay no federal income taxes. This applies to the current tax structure, which admittedly could change depending on what's in the final tax cut package -- and if it passes. 

The lawmakers are clear that Rothifying 401(k) contributions will help pay for their proposed tax cuts. This removes any doubt that middle-income workers might experience a tax increase due to this feature of the tax cut package.

Middle-income workers might rightly ask if such a tax increase is a fair price to pay for a tax package that will mostly benefit wealthy taxpayers? According to one analysis, half the benefits of the proposed tax cuts would accrue to the wealthiest 1 percent.

Paul Ryan doesn't rule out possible changes to 401(k) plans 09:29

Lawmakers are also considering eliminating the deduction for state and local income and property taxes, another potential feature of the tax cut package that could hurt the middle class, particularly those in high-tax, Democratic states such as New York, New Jersey and California.

Why are Republican lawmakers attacking how middle-income workers save and invest but not proposing reductions or an end to the special preference granted for capital gains, which affects the way many wealthy people save and invest? Changes to the latter could also help pay the bill for tax cuts. 

The tax expenditure for the special treatment of capital gains, including the stepped-up basis of capital gains upon death, is more than twice as large as the tax expenditure for defined-contribution retirement plans like 401(k)s, according to an analysis by the Tax Policy Center.

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