First, there were trial balloons about Republicans paying for a tax cut in part by scaling down the 401(k), tax-free retirement savings system, where you save on taxes now but pay them later at retirement when you may be in a lower tax bracket. (The proposed annual contribution limit: $2,400.)
Then, President Donald Trump tweeted he doesn’t want Congress to target 401(k)s. Subsequently, the powerful chair of the House Ways and Means Committee suggested the president’s tweet does not change whatever his tax committee might be considering.
Let’s get practical here about the alternatives if Congress were to lower the limit on 401(k) contributions. Joseph Cordes, an economics and public policy professor at George Washington University, stopped by to chat with us about the ongoing controversy and the different retirement options that are available to Americans. Below is an edited transcript of the conversation.
David Brancaccio: So the president doesn’t want to curtail the 401(k) system, but as a proposal, it’s not completely dead. Let’s talk about this. A company that offers a 401(k) retirement savings plan, I suppose, could convert to the other system, right? Is that an option available now under U.S. law?
Joseph Cordes: I believe it is to the extent that you want it to still provide some incentive for people to save for retirement. If Congress were to decide to curtail the current deductible 401(k)s, I would expect them to provide a Roth option as an alternative.
Brancaccio: Now the Roth, of course, is where you pay the taxes now. But when it presumably goes up over the years when you show up at retirement, you don’t have to pay on the capital gain. You don’t pay taxes again.
Cordes: Yeah, you pay taxes up front and then you don’t pay them again.
Brancaccio: What do we know about this system as an incentive to save? You know, you’re at tax time. A good way to lower that year’s tax bill is to kick a little bit more money, if you can, into the 401(k) system. That wouldn’t work if they shifted to “We’ll tax you now and not later.”
Cordes: From a formal economic perspective, if, for example, the individual’s tax rates did not change over their lifetime, one can demonstrate that the deductible 401(k) and a Roth 401(k) would, under some fairly plausible assumptions, actually give you the same overall lifetime result. However, if we bring in some of the insights from behavioral economics, one might conclude that people would prefer to get the goodies now rather than later.
Brancaccio: Now one benefit companies offer is matching your tax-free retirement contribution. If there were a conversion to the tax-me-now-not-later system, I guess we’d need some creative thinking to engineer an equivalent fringe benefit.
Cordes: Well, I think that’s exactly right. And I’m sure there are ways to do it, and I would assume that the Treasury would facilitate the ability to do that. Because once again, playing out in all of this in the background is, of course, a considerable amount of concern that middle-income Americans are not saving enough for their retirement.