The Irony of Taxing 401k Plans to Save Social Security

The Irony of Taxing 401k Plans to Save Social Security

February 06, 2024

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The Irony of Taxing 401k Plans to Save Social Security
by Christopher Carosa February 06, 2024

A few weeks ago, two well-known retirement researchers published a report that raised eyebrows, (see “The Case for Using Subsidies for Retirement Plans to Fix Social Security,” by Andrew G. Biggs and Alicia H. Munnell, Center for the Retirement Research at Boston College, January 16, 2024). The report concluded, “reducing tax expenditures for retirement plans could be an effective way to help address other pressing demands on the federal budget, such as Social Security’s financing shortfall.”

Biggs and Munnell claim tax incentives to save for retirement are “a very bad deal for taxpayers,” because they “primarily benefit high earners.” As a result, the authors state “the tax expenditure has failed at its broader policy goals of increasing national saving or expanding plan coverage.”

Is this a good idea? Or will it throw out the baby with the bathwater?

“There are controversial proposals to repeal or curtail the ability for employees to save on a pre-tax basis in defined contribution plans (and IRAs) arguing that it would be better to tax that income and use it to fund Social Security,” says Michelle Capezza, of counsel at Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. in New York City. “While employee pre-tax elective deferrals are not current income for federal tax purposes, they are considered wages subject to Social Security (FICA), Medicare and federal unemployment taxes (FUTA). Thus, these employee 401k contributions, for example, are already subject to FICA taxes which fund Social Security. Workers need a viable way to save money for their non-working years and shouldn’t be penalized for doing so by further curtailing their efforts.”

Experienced retirement professionals see this as an academic exercise that underplays the practical consequences of implementation.

“Nothing good about this idea,” says Jack Towarnicky, of counsel at Koehler Fitzgerald, LLC in Powell, Ohio. “The authors confirm it will reduce retirement savings and negatively impact retirement preparation. The proposal appears to remove tax preferences for all tax-qualified plans (DB & DC pensions, 401k, 403b, 457, IRA, ESOP, etc.) on future contributions – focused on raising revenue in the current 10-year budget window period, while continuing to apply tax deferral on already accumulated assets, until they are distributed. It is not without precedent, however. The 1983 Social Security changes moved employee deferrals from being pre-tax for FICA and FICA-Med to after-tax. For comparison, employer contributions to plans with 401k features continue to be pre-tax for FICA and FICA-Med purposes.”

This might be a classic case of fixing something that isn’t broken.

“I don’t think this is a good idea,” says Jason Grantz, managing director at Integrated Pension Services in Highland Park, New Jersey. “The private sector retirement system is a HUGE pool of untaxed moneys. This is always tempting for certain political personalities instead of doing the difficult work of fixing social security. They’d rather break something else that works well and is easier to raise money from.”

Harold Evensky, the dean of financial planning and founder of Evensky & Katz in Lubbock, Texas, says, “Other than it’s a sneaky way for Congress to avoid having to deal with a Social Security shortfall there is no rational basis to have investors 401k fuel any shortfall. At a minimum one result will be to discourage retirement savings.”

This seems to be the prevailing thought of retirement plan service providers.

“Taxing 401k plans could discourage retirement savings, potentially hindering individuals’ ability to accumulate sufficient funds for their retirement,” says Tyler Meyer, president/financial planner at QED Wealth Solutions in Kingman, Kansas. “It may disincentivize participation in retirement plans, particularly among younger workers, jeopardizing long-term financial security. The simple fact is that this is not the place to start. Long before they look at making any significant switch within retirement accounts, they should look to remove the social security wage cap.”

The paper acknowledges that “reducing these tax incentives could, perhaps, somewhat reduce interest among employers in offering work-based savings plans.” Still, it suggests “alternative arrangements could be made to ensure that all workers have an organized way to save for retirement.”

“At least one author of the study asserts that people don’t save if there is no employer-sponsored or payroll deduction plan,” says Towarnicky. “The proposal would remove all tax preferences on future contributions. Some, many, most (?) employers will likely freeze their plans. Contributions won’t be tax deductible, earnings won’t be tax deferred – administration would likely be significantly increased to separate assets accumulated prior to the change.”

Worse, if the “alternatives” alluded to by the paper entail government-backed programs like Social Security, this could have a debilitating impact on encouraging people to be responsible for funding their retirement.

“Encouraging individuals to be responsible for funding their own retirement fosters financial independence and reduces the strain on government-sponsored programs,” says Meyer. “It empowers individuals to take control of their financial futures, promoting a sense of personal responsibility. This approach aligns with the principles of self-reliance and financial literacy, fostering a more sustainable retirement landscape.”

People who rely on themselves to accomplish something take ownership of that activity. “The more individuals take responsibility for retirement the less potential indigents fall on the state to support,” says James Koutoutlas, president and co-founder of the Commodity Customer Coalition in Miami Beach, Florida.

“When individuals are encouraged to save for their retirement, it leads to increased personal savings,” says Richard Bavetz, investment advisor at Carington Financial in Westlake Village California. “This helps ensure they have sufficient funds to achieve parity when they retire by maintaining their standard of living in retirement. By having a personal retirement fund, individuals are less reliant on Social Security or government pension plans, which may be uncertain due to unfolding economic factors. Promoting financial literacy is essential in changing an individual’s attitude toward money, their overall savings habits, and investor behavior. Long-term retirement health cannot be improved through government babysitting plan investors. Individuals need to take personal responsibility for their retirement plans.”

Indeed, more than just common sense, studies show the correlation between personal savings and retirement success.

“Savings Rate is by far the most powerful contributor to a successful income replacement rate,” says Grantz. “This is widely agreed upon as true.” Grantz co-authored (with David M. Blanchett) a paper (“Retirement Success: A Surprising Look into the Factors that Drive Positive Outcomes,” The ASPPA Journal, Summer 2011, Vol. 41, No.3) which, he says, “measured the contributing factors to a successful retirement and we concluded that savings rate was worth nearly triple the next most important factor.”

Finally, perhaps the most glaring omission in the paper is the fact that it doesn’t address the real problem it’s attempting to address: unfettered government spending.

“Since the turn of the century, Congress has proven unable to stop increasing spending far in excess of increased revenues,” says Towarnicky. “Federal debt has increased from $5.8 trillion to $34+ trillion. Since the turn of the century, Congress increased federal revenues from $2 trillion to $5+ trillion and raised spending from $2 trillion to $7+ Trillion. Over the past three years, we have had annual deficits in excess of $2 trillion. This proposal would raise approximately $200 billion annually. Congress might just take additional revenues and spend them without reducing either the federal deficit or the gap in Social Security funding.”

Despite what the authors say, the 401k plan has succeeded remarkably. It has turned ordinary workers into retirement millionaires. Has it helped everyone? Of course not. When something works only if you have the drive and discipline to see it through, those without the drive and discipline will fail to take full advantage of the opportunity presented to them.

Still, that’s no reason to punish those who worked hard to achieve their goal.

Christopher Carosa is an award-winning online news producer and journalist. A dynamic speaker, he’s the author of 401(k) Fiduciary Solutions, Hey! What’s My Number? How to Improve the Odds You Will Retire in Comfort, From Cradle to Retirement: The Child IRA, and several other books.