401(k) Rule Change Could Reduce Potential Retirement Savings By 43%

Over the weekend, I read an article in the Wall Street Journal entitled “Grab the Pitchforks, Your 401(k) May Need To Ward Off Congress.” This article, by Jason Zweig, presents a genuinely disturbing scenario of our Government taking away a significant tax advantage of saving in 401(k) accounts, that could reduce an employee’s potential career savings by as much as 43%. Congress is considering discontinuing the ability to save using pre-tax earnings. The article points out that if Congress were to tax retirement plan contributions it would generate an estimated $1.5 trillion in revenues over the next 10 years. The article focuses on the inequity of Congress doing this to taxpayers while not requiring the same of themselves. For these reasons, it calls readers to action to let their congressional leaders know they do not agree.

However, what does this potential rule change mean to an employer interested in offering a 401(k) Plan designed to help employees retire successfully at a mutually beneficial age. What would it mean to the average saver? I’d like to add a dollars and cents piece to the story to hopefully increase your understanding and sense of urgency by using a simple analysis.

For employers with an employee earning $60,000 a year, as an advisor, I would recommend a savings rate of 10% to 15% of salary including any matches and other employer contributions. The single most important factor in succeeding in saving for retirement is most often the amount saved. In this analysis, I assumed the following:

Keeping it simple, I assumed a level salary over a 35 year career. With the employer’s $75 match, which is pre-tax for the business, the employee will save $325 and by saving pre-tax, her take home pay is $1,688 per period. Remember, these accounts grow tax deferred under current rules, meaning that dividend income, interest and capital gains are not taxed. Under these assumptions, after 35 years of average annual market growth of 6%, the account value would be $931,146.

If Congress were to take away the ability to save with pre-tax dollars, the analysis assumed that the employee would still desire take home pay of $1,688. In order to achieve this, the employee would only be able to defer $188, and in this scenario the employer would still match the $75 for a total per period contribution of $263. Again, assuming a 6% average annual growth rate, the employee would end a 35 year career with $745,681 or $185,465 less than she did with the ability to save pre-tax.

However, I’m not sure that the above analysis takes into account the full effect of Congress’ actions. Would Congress continue to allow employers to deduct matching contributions? If not, the employer would be less likely to contribute the $75 match and the employee would only save a total of $188 per period. Under this scenario, at the end of 35 years the employee would have saved $532,629 or $398,516 less than she did before Congress removed the tax benefit.

I kept this analysis simple to illustrate the point that due to the compounding effect of saving, Congress’ attempt to raise revenue by taxing retirement savings can have a devastating impact on an employee’s 401(k) account over a 35 year career. In this scenario, the account value was reduced by 43%. If the inequity of what Congress is considering isn’t enough to make you want to call your congressional leaders, maybe the potential loss of almost half an employee’s savings over a career will be. With this in mind, business owners as well as employees saving for retirement should let Congress know how important pre-tax saving in a 401(k) account is to their futures.