Tax Reform: Is Your 401(k) Going Away?
By: Matt Carey - December 22, 2017
Sounds great, right? Well, what’s the actual proposal to do that? We don’t know yet, but Politico and other news outlets are starting to report what it could look like. And the changes are pretty drastic.
Read on to find out what changes are being considered, how likely they are to be enacted, and what they’d mean for you if enacted.
What Wouldn’t Change
First, it’s highly unlikely that the tax treatment of money you’ve already contributed to a 401(k) would be impacted. It’s fair to say that your existing 401(k) balance will be grandfathered into the current tax treatment.
Second, it’s also highly unlikely that in a new system there would cease to be a tax incentive for retirement. Beyond just collecting revenue to finance government spending, tax policy is intended to incentivize good behavior, and there’s broad bipartisan agreement that saving for retirement constitutes good behavior.
What Would Change
The shift that’s being contemplated is to tax retirement savings when you make contributions, but not when you withdraw the funds in retirement. This is the opposite of the way that the current 401(k) works.
Let me briefly explain how tax treatment differs for a 401(k) and a Roth 401(k), since the shift from the former to the latter is likely to be at the heart of the proposal.
Contributions to a traditional 401(k) are made pre-tax, and then withdrawals (the money you take out during retirement usually) are taxed as part of ordinary income. A Roth 401(k) is the opposite. With a Roth 401(k), contributions are taxed and withdrawals are tax-free.
Which is better for you? There’s no universal answer, but generally the rule is that if you believe (a) overall taxation will go up in the future and (b) you’ll be in a higher tax bracket in the future, then a Roth is better. If the opposite is true, then a traditional 401(k) is better. If you believe (a) but not (b) or (b) but not (a), then it’s anyone’s guess what you’ll be better off doing.
Which is better for the government? Well, the reality is that the government should be indifferent, but because of the way budget math works, the government favors more tax revenue up front (hence the impetus for changing the system). In a normal 401(k) world, the government collects no taxes now but lots later. In a Roth 401(k) world, the government collects taxes now but none later.
The budget window for tax reform policies like this is 10 years in length. So a change from traditional 401(k) to Roth 401(k) will look like the government is doing a better job balancing the budget. But in reality it’s just more money now (in the 10 year window), at the cost of tax revenue later. It’s a can kicked down road kind of thing. The idea behind making this change is that it makes the tax cuts the President and his Republican colleagues want to implement seem less costly as part of a full package of tax reform.
So What’s Actually Going To Happen?
Full-fledged tax reform seems unlikely, especially in the current political climate. But if it does happen, I would think that a switch to Roth 401(k)s is more than likely going to be part of it. It’s hard to see how a switch to a Roth 401(k) would hurt individuals, and since it would make the government collect more revenue up front in order to pay for tax cuts, it may be a hard change to argue with as as part of a broader reform package.
Article source: Forbes.com
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