To save Social Security, they may come before your 401(k).

By | February 23, 2024

Wait what?

Wait what? – Getty Images

Looks like we better boost our 401(k) and IRA contributions to the absolute maximum while we still can, folks.

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That means a full $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 make additional contributions . It may also mean converting your pre-tax traditional IRA to an after-tax Roth IRA to maximize the after-tax amount in your shelters.

The reason? There is talk in policy circles about abolishing these plans altogether – or at least ending the tax breaks, which is pretty much the same thing. That would be a political shock and a financial earthquake, especially for the middle class.

Policy experts argue that these bills mainly benefit very high earners, while doing little to increase savings. They want to use those extra taxes to save social security, which is heading for 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 shelters a “fraud” that primarily benefits the wealthy.

Right now, no one is talking about anything retroactive: they wouldn’t be raising taxes on money already deposited into these accounts. Rather, the idea would be to end the tax deduction in the future and replace it with another system that does not offer the same deduction.

How serious is this? Nobody knows. Right now it’s just talk. But social security is in crisis. Ultimately, they will have to cut benefits or raise taxes.

The argument against 401(k) plans and IRAs is that they are regressive: they benefit high earners most. That’s not entirely untrue. Clearly, if someone pays a higher tax rate, he or she will benefit more from a tax deduction. If you contribute the maximum amount of $23,000 to a 401(k) plan and you fall into the top federal tax bracket of 37%, you’ll shave $8,500 off this year’s tax bill. If you’re in the 15% federal tax bracket, you’ll save less than $3,500.

But there are several problems with this reasoning.

As MarketWatch’s Robert Powell noted when this idea first surfaced a while ago, these accounts keep people from avoiding taxes entirely. They just postpone them. Reports about the regressive nature of the tax benefit may therefore be exaggerated.

And yes, tax shelters help the rich, but also the middle class – who often really need them. These plans can make a real difference for families trying to save for retirement while at the same time making ends meet and saving for their children’s college education, for example. Torpedoing a lifeboat used by the middle class because it might also contain rich people seems very 1917.

Meanwhile, high earners only get a bigger tax deduction on their contributions because… um… they pay more taxes in the first place. Obvious, but worth repeating.

It’s also not entirely clear how regressive these tax shelters really are. If you work in middle-income jobs all your life, save aggressively, and take advantage of luck and a bull market, you can retire with a huge 401(k) balance. Lucky you. But you may pay a higher tax rate on the withdrawals than on the contributions, so you may not be that much better off after all.

That’s not a complaint, that’s an observation. It’s how the system is supposed to work. It’s progressive. On the other hand, if you retire with very little money, you will pay very little tax on your withdrawals.

These tax shelters also have a number of important practical benefits for savers. They help people invest in bonds, for safety, but also in stocks, for growth. Bond income and interest income are generally taxed at much higher rates than stock income. Tax shelters give people the freedom to change and rebalance their portfolios without incurring additional taxes. By the way, and this is no small feat, they also free people from absolutely insane, stupid, and largely pointless IRS paperwork every year.

These tax shelters are also simple and make intuitive sense. I pay taxes on my income, which is money that I can use immediately. I won’t be able to use my retirement savings for decades. I only pay tax on that when I withdraw it from the account to spend it.

According to Boston College’s calculations, ending tax-deferred 401(k) plans and IRAs would generate $185 billion a year in additional taxes.

You know what else would make almost exactly the same amount? Just a small – minuscule – tax on the assets of the super-rich.

According to Federal Reserve figures, the richest 0.1% now owns 12.4% of all wealth in America. In the late 1980s, during the era of Ronald Reagan and George HW Bush, this group owned 7.6% of the wealth.

Their total assets now amount to $20 trillion. A 1% tax would raise $200 billion without affecting the retirement savings instruments of the middle class.

Many of these wealthy people, fortunately for them, pay very little or no taxes at all. They may not even appear in the IRS tables of “high earners.” You may remember that a decade ago someone from this group ran for president and released his tax returns. Turns out Mitt Romney didn’t pay a 50% or 37% rate, he paid a 14% rate. And many of the really, really, really rich pay even less – or nothing.

Historically, the average return on equity has been approximately 10% nominally. So a 1% tax is bupkis.

But such a tax is unlikely to happen. It would upset the donor class. Instead, maybe they come for you and me. As analysts noted a decade ago, the rich get what they want from Washington time and time again. And while people can criticize the American system all they want, it is still the best money can buy.

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