401(k) legislation: Republican tax reform bill for contribution limit decreases in 2018

The 401(k)’s high contribution limit has helped many American workers create a sizable collective piggy bank – estimated at $6.7 trillion in assets by the Investment Company Institute as of December 31, 2020. As lawmakers draft the latest approaches to tax reform, the are looking to enact several tax cuts, they have to come up with a few ways to balance the budget. Several political analysts, tax consultants, and financial industry experts are pointing out that those same lawmakers are eyeing the retirement piggy bank and considering capping the current 401(k) contribution limit from $20,500 to a rock-bottom $2,400.

Why is the Republican tax plan looking to reduce the 401(k) contribution limit?

One of the key 401(k) tax advantages is that you can defer taxation until retirement age when you’re more likely to be in a lower tax bracket. In 2017, you can sock away up to $18,000 in a 401(k), meaning that you can reduce your taxable income by up to $18,000. That’s $18,000 worth of income that you can defer paying taxes for, which means that’s tax money that the government isn’t able to collect today.  With a much lower 401(k) contribution limit, you would be forced to save for retirement through alternative vehicles, such as an IRA, Roth IRA, or Roth 401(k).

This idea isn’t new. In 2014, former chairman of the House Ways and Means Committee, Dave Camp, proposed letting people defer half of their annual contributions and have the government collect federal income taxes on the other half.

Since contributions to a traditional IRA are capped at $7,000 ($8,000 if age 50 and over), you would end up either saving with after-tax dollars at an individual investment account or after-tax retirement savings account. Either way, the federal government would end up collecting more in income taxes in the near future to help balance the budget.

This is a near-term fix, since right now, with a relatively high contribution limit, the tax payments are deferred to decades later — at the point that most people take out their 401(k) funds for retirement, their tax bracket is much lower, so the tax payment also ends up being not only delayed (from the government’s perspective) but also just a smaller amount. The tax reform mandate of Republican leadership is to make tax reform revenue neutral, which means that any tax cuts have to be paid for with revenue from somewhere else. In this case, your retirement savings.

A brief history on 401(k) limit decreases and increases since 1978

The 401(k) as we know it today didn’t really start until 1986 when deferred employee contributions were set at $7,000. Back in 1978, the original 401(k) legalese allowed employees to defer up to $45,475! While this may seems crazy, we have to remember the high inflation we had back then.

Early on, the contribution limit for employee deferred contributions was knocked down substantially In 1982, the $45,475 limit was decreased to $30,000 and in 1986, decreased again to $7,000. But ever since 1986 it has always increased:

The ICI provides a very complete history of the 401(k), which you can read about here.

But didn’t the IRS just announce an increase to 401(k) contribution limits for 2018?

Yes, it did. In October 19, 2017, the IRS officially announced that the contribution limit to 401(k) plans in 2018 would increase from $18,000 to $18,500. The current $18,000 limit was set back in 2015 so this bump has been expected for quite some time by analysts keeping an eye on the consumer price index.

The confusion around higher IRS limits being announced the same time that news outlets are talking about legislation for lowering the limits hasn’t gone unnoticed. On October 23, 2017, President Trump tweeted: “There will be NO change to your 401(k). This has always been a great and popular middle class tax break that works, and it stays!” This is not the first time that the White House has stated that 401(k) contributions won’t be affected. Back in April, White House officials clarified that President Trump’s tax plan won’t eliminate deductions for plan participants.

In the end, we’ll have to wait until the scheduled release of the Republican tax reform bill on November 1, 2017.

How has the market reacted to this confusion?

The financial industry has reacted in two main ways.

First, several companies and think tanks are researching the impact of the Rothification of retirement savings. In layman's terms, what would be the effect of saving with after-tax dollars? For example, the Employee Benefit Research Institute (EBRI) is currently studying how saving with after-tax dollars affects retirement outcomes. There are some studies already out there, such as the one from Harvard University that found no evidence that total 401(k) contribution rates differ between employees hired before versus after a Roth option was introduced to a 401(k) plan. The consensus is that more research is needed.

The main challenge for plan administrators is the low percentage of Roth 401(k) adoption. At year-end 2016, 65% of Vanguard 401(k)’s offered a Roth feature and only 13% of plan participants within those plans had elected the option. Just four years earlier, only 49% of Vanguard plans offered a Roth feature and 10% of plan participants chose the Roth feature.

Second, many industry leaders have spoken against the proposed contribution decrease. Ascensus, Fidelity, Northern Trust, and Wells Fargo are among several business that have advocated against the forced Rothification of retirement savings. Other members include the Investment Company Institute, TIAA CREF, and the EBRI.

“It would marginalize a key incentive for Americans to save, particularly among low- and middle-income workers”, stated Dave Gray, a retirement product leader at Fidelity. A spokeswoman for Vanguard, Laura Edling shared the same concern as Gray in an email statement to Bloomberg stating that the company is “greatly concerned over any legislation that would negatively impact investors’ ability or incentive to save for retirement. The 401(k) plan is the cornerstone of the future retirement security of millions of Americans.”

Should you do anything differently with your 401(k) before the end of 2017?

There are two clear steps:

First, you should already be doing this: maximize your pre-tax contributions to your 401(k) for 2017. Remember that you can adjust your paycheck contribution as many times as you wish throughout the year. The sooner, the better, though — some plans may have a waiting period to process your contribution change, depending on how often your payroll is run.

Additionally, any bonus or commission checks issued by your employer before Tax Day 2018 or the date that you file your return, whichever is earlier, are also eligible for your 401(k) contributions for 2017.

Another good reason to maximize your 401(k) pre-tax contribution for 2017 is that it may allow you to fall within the income limit threshold to qualify for the 401(k) Saver’s Credit.

Second, educate yourself about ways to save for retirement with after-tax dollars, just in case. In the event that pre-tax contributions to your 401(k) were to be greatly reduced, you would need to become more familiar with Roth retirement accounts and their tax implications. Here is a list of resources to get you started:

• 401(k) vs. Traditional IRA vs. Roth IRA vs. myRA

• Roth 401(k) vs Roth IRA: Where Should You Put Your After-tax Dollars?

• Roth 401(k) vs. Traditional 401(k)

• Pre-tax vs. Post-tax 401(k): Why a Roth 401(k) is Better for Younger Workers

We hope you found this helpful! It’s been a hectic time in 401(k) news, which can be frustrating — uncertainty and instability are the last things you want when planning for long-term retirement savings. Keep in mind that 401(k)s are very popular and well-supported, both currently and historically. If you have any questions about what’s going on, feel free to comment below.

Update: November 3, 2017

On Thursday, November 3, 2017, House Republicans unveiled their tax bill. While there are a couple of proposed changes to rules governing 401(k) plans, the contribution limit to your 401(k) will stay at $18,000 for 2017 and increase to $18,500 in 2018 as announced by the IRS earlier in October.

As Republican legislators appear to have compromised on 401(k) contribution limit, the rumored drop to a $2,400 limit is now highly unlikely.

You can review the full text here. Proposed changes affecting 401(k) plans and other types of retirement plans start on page 143.

5 proposed key changes to your 401(k)

1. Elimination of wait period for contributions after hardship withdrawal

Currently, employees are generally prohibited from making contributions to their workplace 401(k) plan for at least 6 months after receipt of a hardship distribution. The Republican tax bill seeks to do away with this restriction and enable employees to continue their contributions despite the hardship withdrawal.

If you’re considering taking an early distribution due to hardship, first read 401(k) Early Distribution: Is It Worth It?

2. Increase of pool available for hardship distributions

Under current 401(k) rules, you can only take hardship distributions from your own paycheck contributions. This means that your maximum distributable amount generally doesn’t include earnings, qualified nonelective contributions, or qualified matching contributions.

Republican leadership seeks to make contributions to a profit-sharing plan or stock-bonus plan, qualified nonelective contributions, qualified matching contributions, and earnings on any contributions all eligible for distribution upon hardship of an employee.

3. Extension of grace period to pay back 401(k) loans

One of the many reason why it doesn’t make sense to take a loan from your 401(k) is that the unpaid balance from your loan becomes due within 60 days of the date of separation from your employer. If you can’t pay it back, then the loan becomes taxable income, triggering applicable income taxes and penalties, such as the 10% early distribution fee if you’re under age 59 1/2.

The language of the Republican tax bill includes a clause to increase the grace period to pay back an outstanding 401(k) loan after separation from employer until tax day of the next year or the date that you file your return, whichever is earlier.

4. Lowering the age for qualified distributions for other types of retirement accounts

Another 401(k) tax advantage is that you can start making qualified distributions at age 59 1/2. However, some state and local governments with 403(b) or 457 plans set the age at 62. Since this section of the tax bill looks to simplify and reform savings, pensions and retirement, Republicans look to set the start age for qualified distributions at age 59 1/2 across all types of defined contribution retirement plans.

5. Adjustment to non-discrimination testing

While non-discrimination testing of employer-sponsored 401(k) plans is well-intentioned, it can be both confusing and inconvenient for employers who just want to offer a way to help employees invest in their futures. According to a study by retirement plan data publisher Judy Diamond Associates, almost 60,000 plans nationwide failed their most recent nondiscrimination tests, resulting in $794 million in corrective refunds to employees!

Some companies may offer both an older defined benefit plan and a defined contribution plan, such as a 401(k). In an effort to protect older, longer service, and grandfathered participants in those defined contribution plans, Republican legislators are looking to allow such plans to fold in the company’s defined contribution plan when doing nondiscrimination testing. This would allow holders of both types of plans to continue accruing benefits; and employers to minimize costs of non-discrimination testing and avoid having to shut down the defined benefit plan.

As the Republican tax bill continues to be revised, 401(k) plan holders across the nation will stay tuned to see the actual changes that get implemented.