Looks like we’d better boost our 401(k) and IRA contributions to the absolute maximum while we can, folks.
That means a total of $30,000 this year, and more if you’re 50 or older: The 401(k) maximum for 2024 is $23,000 and the IRA maximum is $7,000, and savers who are 50 or older can pay additional contributions. It could also mean converting your traditional pre-tax IRA to an after-tax Roth IRA in order to maximize the after-tax amount in your shelters.
The reason? There is talk in political circles of eliminating these plans entirely – or at least ending the tax breaks, which amounts to much the same thing. It would be a political shock and a financial earthquake, especially for the middle class.
Policy experts argue that these accounts primarily benefit higher income earners, while doing little to boost savings. They want to use those extra taxes to save Social Security, which is hurtling towards a crisis.
Allison Shrager of the Manhattan Institute just wrote about this idea. Boston College’s Center for Retirement Studies wrote about it last month. University of Virginia law professor Michael Doran helped get the ball rolling a few years ago, calling these middle-class tax havens a “fraud” that primarily benefits the wealthy.
At the moment no one is talking about anything retroactive: they would not start imposing taxes on money already paid into these accounts. Rather, the idea would be to eliminate tax deductions in the future, replacing them with another system that does not have the same deductions.
How serious is this? No one knows. At the moment it’s just talk. But Social Security is in crisis. Eventually they will have to cut benefits or raise taxes.
The argument against 401(k) plans and IRAs is that they are regressive: they benefit higher earners the most. This is not entirely false. Clearly, if someone pays a higher tax rate, he or she will get more benefit from a tax deduction. If you contribute the maximum $23,000 to a 401(k) plan and are in the highest federal tax bracket of 37%, you’ll shave $8,500 off your tax bill this year. If you’re in the 15% federal tax bracket, you’ll save less than $3,500.
But there are multiple problems with this line of argument.
As MarketWatch’s Robert Powell pointed out when this idea first came up a while ago, these accounts don’t allow people to avoid taxes entirely. They just send them back. Therefore, reports of the regressive nature of the tax relief may be exaggerated.
And yes, tax havens help the rich, but they also help the middle class, who often really need it. These plans can make a real difference for families trying to save for retirement and also, for example, to save for their children’s college education. The torpedoing of a lifeboat used by the middle class on the grounds that it could also carry rich people seems very typical of 1917.
Meanwhile, higher earners get a bigger tax break on their contributions just because… er… they pay more taxes in the first place. Obvious, but worth repeating.
Furthermore, it is not entirely clear how regressive these tax havens really are. If you work all your life in middle-income jobs, save aggressively, and take advantage of luck and a bull market, you could retire with a huge 401(k) balance. You are lucky. But you could end up paying a higher tax rate on withdrawals than you would have paid on contributions, meaning you might not be better off at all.
That’s not a complaint, it’s an observation. This is how the system is supposed to work. It’s progressive. If you end up retired with very little money, on the other hand, you’ll pay very little tax on your withdrawals.
These tax havens also bring a number of important practical advantages for savers. They help people invest in bonds, for safety, as well as stocks, for growth. Bond income and interest income are generally taxed at much higher rates than stock income. Tax havens leave people free to adjust and rebalance their portfolios without triggering additional taxes. Incidentally, and this is nothing, every year they also free people from absolutely crazy, stupid and largely useless IRS practices.
These tax havens also make simple, intuitive sense. I pay taxes on my income, which is money I can use right away. I can’t use my retirement savings for decades. I will only pay taxes when I withdraw it from the account to spend it.
According to Boston College calculations, ending tax-deferred 401(k) plans and IRAs would raise $185 billion a year in additional taxes.
You know what else could raise almost exactly the same amount? Just a small – tiny – tax on the assets of the super-rich.
According to Federal Reserve data, the richest 0.1% now own 12.4% of all wealth in America. In the late 1980s, during the era of Ronald Reagan and George H. W. Bush, that group owned 7.6 percent of the wealth.
Their total assets now amount to $20 trillion. A 1% tax would raise $200 billion without touching middle-class retirement savings vehicles.
Many of these wealthy people, fortunately for them, pay very little, if any, taxes. They may not even appear in the IRS “high income earner” tables. You may remember when someone from this group ran for president ten years ago and released his tax returns. It turns out that Mitt Romney wasn’t paying a 50% or 37% rate, but 14%. And many of the really, really, really rich pay even less – or nothing at all.
The average return on capital, historically, has been around 10%, in nominal terms. So a 1% tax is a bupkis.
But such a tax is unlikely to be applied. It would shock the donor class. Instead, they might come for you and me. As analysts pointed out a decade ago, the rich get what they want from Washington, over and over again. And while people can criticize the American system all they want, it is still the best that money can buy.