The holiday season is fast approaching. It is a time most people feel more generous to loved ones or to the less fortunate. Not so when it comes to Congress.
If lawmakers have their way, taxpayers may have to work longer in their lives, work more hours or have to take more risk in the investment markets to live the retirement they envision now.
This is what reducing the 401(k) plan contribution limit could mean. This is what Congress is calling "tax reform."
There are 54 million American workers participating in about 550,000 401(k) plans, according to the Investment Company Institute. These plans hold more than $5 trillion in assets. This tax reform measure will most likely affect the wealth of most American households and certainly affect the way they save for retirement.
A person can make a contribution to his or her 401(k) plan of a maximum of $18,000 (in 2018, this is slated to be increased to $18,500). This contribution is tax-deferred. In other words, you don't pay tax on the $18,000 of income you earned and contributed into your 401(k) plan.
However, when you withdraw from your savings in retirement, you will then pay tax on what you contributed and the money you earned from investing it. For those over age 50, there is an option called a "catch up" that allows another $6,000 to be contributed tax-deferred.
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The GOP, as has been widely reported, is tinkering with reducing this tax-deferred contribution to $2,400. To make this even more confusing, in a sharp reversal, Rep. Kevin Brady, a top tax writer in the House of Representatives, indicated that lawmakers may look at raising contribution limits to $20,000 or more.
If you are going to pay taxes on this money anyway, you might be wondering what is the big difference in paying the tax now or later. The short answer: It could be a lot. The longer answer: You will not be able to take as much advantage of the principle of compounding resulting in a loss of a lot more wealth in your life.
Compounding is the earning of money on the money invested. When added to your original investment, it forms a larger base on which to earn more money. Most understand this concept. Most do not understand the power compounding brings to building wealth over a long period of time.
Let's say a 40-year-old person saves $18,000 in a 401(k). Assuming an average annual return of 6 percent, by the time he or she reaches age 65, this one-time contribution will grow to about $77,000. If the money had not been placed in a 401(k) but rather in a mutual fund or other investment outside of the plan, the account holder would have had to pay tax on the $18,000. Assuming the effective tax rate between federal and state is at least 25 percent, he or she will pay $4,500 in taxes, leaving only $13,500 to grow for retirement.
Worse, the 6 percent return would also be taxed. So, the account holder might wind up only earning 4.5 percent, or 25 percent less, due to taxes each year.
That $13,500 dollars growing at 4.5 percent for the same 25 years would result in a total of a little more than $40,000, or $37,000 less than if the funds grew in the 401(k). This is 48 percent less wealth the person would have for retirement even though he or she lost just 25 percent in savings and in earning power due to taxes.
This, of course, is the power of compounding.
Imagine if this 40-year-old could save the $18,000 per year each year for 25 years with the assumptions above. He or she might have up to $1.047 million in a 401(k), versus about $629,000 in investment outside the 401(k) plan by age 65. This is a difference of $418,000 in retirement wealth. This difference could be many years of retirement income for most Americans.
The Republican proposal that has been bantered about is not taking all of the tax and growth benefits away but rather reducing the $18,000 annual tax-deferred contribution limit to just $2,400. So, the $418,000 gap illustrated would be less, but still very substantial.
How would someone make up this retirement wealth gap? Certainly most would have to work years longer to retire with the same wealth. You could work harder. Get still another job to make up for the tax bite.
Or maybe you could gamble more, and take more risk in your investment portfolio to get the average annual return you earn higher than 6 percent. None of these options appear attractive to most.
Of course, another alternative to help close this gap is being less generous this holiday season — and for many to come.
— By Al Zdenek, CPA, founder and president/CEO of Traust Sollus Wealth Management