Proposal Would Eliminate 401(k) Tax Deduction

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The U.S. Senate Finance Committee will hear a proposal today (Thursday) that would eliminate the 401(k) tax deduction in favor of a tax credit.

The presentation by the Brookings Institution will be one of several at a hearing intended to explore ways to encourage workers to save more money for retirement.

Getting people to save more on their own is a goal that's taken on greater importance as Congress has considers reforms to the Social Security program, which is projected to run out of money in 2036.

Most of the possible changes Congress makes to Social Security to keep the program solvent will reduce benefits to future retirees, which means workers will need to start saving more now.

It's clear that U.S. workers are not saving enough - Boston College's Center for Retirement Research has estimated the gap between what Americans have squirrelled away for their golden years and what they'll need at $6.6 trillion.

"Consideration of reforms to strengthen the private retirement system would be appropriate and constructive, especially since any plausible long-term fiscal plan will involve some reductions in Social Security and Medicare benefits," William Gale, a senior fellow at the Brookings Institution, said a briefing last week.

The Brookings proposal eliminates the 401(k) tax deduction, which it says favors high-wage workers, and replaces it with a tax credit that would put money directly into workers' retirement accounts.

As it stands now, a worker in the 15% tax bracket gets back just $15 for every $100 contributed to his 401(k) account. A high-wage worker in the 35% tax bracket, however, gets $35 back for every $100 contributed.

Should the 401(k) tax deduction be replaced with a 30% credit for everyone, each worker would get $30 back for every $100 contributed.

401(k) Killer?

Brookings says the proposal would encourage lower wage workers to save more, but some are concerned about unintended consequences.

For example, the government's match would satisfy the nondiscrimination standards that otherwise encourage employers to offer 401(k) programs.

"It's amazing to me how folks who've never worked in the industry can attempt to fix perceived problems with ideas that would devastate our current system," Brian Graff, CEO of the American Society of Pension Professionals & Actuaries, told Business Insurance.com. "Basically, it would be the end of corporate profit-sharing plans and lead to the termination of hundreds of retirement plans, because business owners would have no incentive to offer 401(k) plans."

Brookings counters that employers will still have other motives to keep the plans as is, such as employee retention.

Others see the Brookings idea as just too radical a change.

"It fundamentally changes the way 401(k) plans work," William Sweetnam, co-chair of Groom Law Group's policy and legislation group, and the former Benefits Tax Counsel in the Office of the Tax Policy at the U.S. Department of the Treasury, told AdvisorOne. "It would be difficult to move a proposal like this in the context of tax reform."

But with budget deficit issues on the brain, Congress may be tempted by retirement reform ideas that can offer some savings.

Congress may be particularly interested in tweaking the tax credit percentage of the Brookings plan to generate revenue. While the 30% credit is revenue-neutral compared with the 401(k) tax deduction, reducing it to 18% would deliver $458 billion to the U.S. Treasury over 10 years.

Of course, that would mean significantly less money going to workers, dampening the incentive to save.

But given the need to get the federal budget deficit under control, squeezing out some extra revenue by swapping the 401(k) tax deduction for a less costly credit might appeal both to Republicans and Democrats - if not this year, then possibly after the 2012 elections.

"Any time they are looking at spending and revenue over the next 40 or 50 years, these issues will be on the table," Dallas Salisbury, head of the Employee Benefit Research Institute, told Reuters.

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