President Obama’s Fiscal Cliff and 401(k)s

Are our 401(k)s at risk from the Obama Fiscal Cliff?  To the extent that they are (and I don’t know that they are), consider some ramifications.  Here’s one way such a risk might unroll:

The Bipartisan Policy Center’s Debt Reduction Task Force has one way to help fix the deficit: reduce 401(k) contributions by 64% using a 20/20 Cap.  Under the 20/20 Cap, contributions would be limited to the lesser of 20% of pay or $20,000 a year.  All those pretax dollars designated for retirement will now be taxable income and Treasury will fill with additional tax revenues.

I’ll leave aside BPC‘s cynical assumption that our money actually belongs to the government, that they’re somehow entitled to it (now there’s an entitlement program…).  Here are a couple of those ramifications.

A single employee who earns $60,000 per year can contribute $17,500 to a 401(k) in 2013.

After taking the personal exemption and the standard deduction, the single employee would be in the 15% federal tax bracket. Under the 20/20 Cap, assuming the 401(k) has a 4% match, the same single employee earning $60,000 per year would be limited to a $9,600 401(k) contribution and will now be in the 25% federal tax bracket paying $1,700 more in taxes.

It’s true that those $17.5k represent 29% of his income, but with disciplined budgeting (he’s single, recall) it’s not so far-fetched.  He will be stretched, but getting hit with an additional $1,700 in taxes will hurt—possibly to the point of blowing up his retirement plans.

With a 64% reduction in contributions, many small businesses may terminate their plans–forcing employees to save money on their own.  After all, why pay plan fees and other administrative costs if the amount of income that can be deferred is reduced to basically the amount of an IRA contribution?

Indeed.  I was chairman of my employer’s 401(k) Plan Board of Trustees a number of years ago.  For our 25-employee company, the typical fee for that sized plan ran to $20,000.  Which is why we had a Board of Trustees and ran our own Plan.  Have the fees changed all that much since?

There’s one more, though, with serious long-range implications.  Reduced contributions to our (private) 401(k) plans while we’re working means a smaller nest egg when we retire.  Which means greater dependence on a Social Security System that will be bankrupt by that day.  Which means both we’re being a greater burden on our fellows in our retirement and we’re living much more poorly than we would have had we been able to accumulate a larger nest egg.

Here’s an example, of just 10 years’ duration.  My wife, being older than 50, is able to contribute, presently, $23,000 per year beginning in 2013.  With the 20/20 cap, that would drop to $20,000 per year.  Note that I’m assuming no changes over the 10 years—including in tax treatment and limit increases.  I’m also assuming a 4% real (after inflation) return on 401(k) investments.

After 10 years, that higher contribution rate will have produced a nest egg of a bit over $276,000, while the limited contribution rate will have grown only to a skosh (that’s the technical term) over $240,000.  That’s a 13% reduction in the value of our nest eggs from such a cap.  Blow that up over 20 years—yes, this contribution rate is possible; you’re in your mid-40s and entering your peak earning years at 20 years prior to retirement.  That nearly 13% annual shortfall only expands the deficiency of the capped 401(k)’s outcome—now it’s nearly $89,500, some 150% greater, short by more than four years’ worth of capped contributions.

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