How Will Potential Changes to 401(k) Plans Affect You?
Understand How the New Tax Laws Could Affect Your Retirement
Potential tax law changes are looming on the horizon. There hasn’t been a major overhaul to the tax code in the U.S. since 1986. But if Congress passes new tax laws you may need to revise your financial plans just a little bit to adapt to those changes.
If you have been paying any attention to the ongoing debates about the pros and cons of these proposed tax law changes it may seem like you have been watching a ping-pong match. It has been a dynamic situation as the details of the income tax bill have changed frequently and it’s never wise to make important financial decisions based solely on rumors and speculation. But the one thing that’s certain is the need to pay attention to how the income tax code will continue to affect how and where you save your money if you are trying to save as much for retirement as possible.
Where does tax reform currently stand? The House of Representatives and the Senate are both moving closer to a final tax version of their respective tax reform bills. While there is no guarantee that Congress will be able pass a tax bill before the end of the year, it is important to understand how new tax law changes could impact your retirement savings.
Here are some important questions to keep in mind as you try to navigate how these pending tax updates relate to your financial plans.
Will 401(k) Plan Rules Change?
Earlier in the year there was growing concern that drastic changes were in store for 401(k) plans. Some lawmakers have been seeking to change the nature of retirement plan contributions from traditional pre-tax contributions to after-tax Roth contributions, in order to collect tax revenues sooner rather than later. In fact, a few of the initial proposals were rumored to limit the 401(k) contribution limits to as little as $2,400 per year, down from the current annual limit of $18,000 in pre-tax contributions.
While most employees don't contribute up to the limit, this still would have significantly reduced the tax incentive for many saver. (You can use this pre-tax savings calculator to estimate your current savings as a result of current year contributions to a traditional 401(k); the potential loss of these tax savings could be significant depending on your actual contribution rate.)
If you participate in a retirement plan through your employer there is some good news. The most recent versions of the tax bills do not appear to drastically change or eliminate how much you can contribute to a 401(k) plan on a pre-tax basis. Tax plan proposals designed to "Rothify" 401(k) plans would potentially discourage workers from saving, and with the retirement confidence levels of many Americans already on shaky ground, many employers, retirement plan providers, and financial planning professionals voiced their concerns about any such proposal.
What Are The 401(k) Contribution Limits for the 2018 Tax Year?
As it stands right now, there are no proposed changes to how much you can set aside in a 401(k). The IRS sets annual limits for maximum contributions you can make to your 401(k) plan. Inflation increased slightly in 2017, therefore the limit was recently adjusted upward. The IRS has already released the 2018 contribution limits for 401(k) plans and the amount you can contribute will increase slightly to $18,500 per year. Catch-up provisions still exist for people age 50 or older allowing for an additional $6,000 contribution.
How Will the New Tax Laws Affect IRA Contributions?
Similar to the belief that 401(k) plans will remain untouched with House and Senate tax bills, Individual Retirement Accounts (IRAs) are also expected to be secure under the most recent versions of the tax reform bills. This means that the $5,500 annual contribution limit will continue for the 2017 and 2018 tax years ($6,500 for ages 50 or older). It also means that traditional and Roth IRAs will still be subject to certain income restrictions which determine if you qualify for either deductible contributions or non-deductible contributions with the benefit of tax-free earnings growth.
Do Lower Tax Brackets Make Roth Accounts More Appealing?
If you are in a higher tax bracket than you anticipate being in when you begin taking distributions from your retirement plan, a traditional 401(k) is often more appealing than the Roth 401(k) benefits of tax-free growth. But with many taxpayers expecting a reduction in their overall tax bills beginning in 2018, it is possible that Roth IRAs will become more appealing. It's also important to recognize that the Roth alternative is optional and not all retirement plan sponsors currently offer a Roth 401(k).
For those that do provide employees with an opportunity to set aside after-tax dollars in an account that provides for the tax-free grow of earnings there may be even greater interest in the Roth alternative.
Will Congress Eventually “Rothify” Employer-Sponsored Retirement Plans?
Under the current tax laws, 401(k) remains a popular retirement savings vehicle, and approximately 52% of retirement plan sponsors in the U.S. offer the Roth alternative. In recent months there has been growing speculation that policymakers would attempt to raise current tax revenues to offset tax cuts under the new proposed tax plan. The term “Rothification” refers to the concept of making most if not all retirement plan contributions with after-tax dollars. A Rothification proposal was initially presented that would involve establishing a new limit on pre-tax 401(k) contributions.
It does not appear the new tax bill will Rothify retirement plans in the most recent iteration of the Senate and House proposals. This does not mean the topic will not resurface again in the future. One thing is certain and that is the Roth 401(k) option continues to gain traction and remains a popular retirement savings alternative if you are seeking tax-free growth of investment earnings.
The Senate vote on the tax reform bill was originally scheduled for December 1, 2017. If the Senate approves their version of the tax bill the House and Senate leaders will then be tasked with reconciling the two plans through a conference committee. Congressional leaders would like to send the final bill to President Trump before the end of the year, but the process could last until January 2018.
Here is a calculator you can use to estimate how the House and Senate versions of the tax reform bill would affect your overall tax situation.
The key takeaways:
- Saving for retirement will remain a top priority for most Americans under the new tax plan.
- Changes in the tax code will require most individuals and families to review (or create) an overall financial plan that incorporates these changes.
- The Pre-Tax vs. Roth decision remains just as important (and complicated) as ever.