On the chopping block: Tax deductions on retirement funds
The new administration is considering tax reform that would exclude tax deductibility for 401(k) and other retirement vehicles. These reforms would involve crafting a more simplistic tax code that would likely lead to fewer options available to consumers.
We understand why this benefit is on the chopping block: according to the U.S. government’s 2017 budget, the windfall to the government of excluding this tax benefit runs to the tune of $1.5 trillion over the next 10 years. However, as we have communicated to our clients over the years, the ability to lower or manage your income with tax deductions through your 401(k), 403(b) and IRA is substantial.
So how might this impact the average American?
The availability of defined benefit pensions among employers has declined dramatically over the past 25 years. The average person must save and create a version of the defined benefit pensions to create income in retirement.
The retirement tax break allows those who fund retirement accounts additional incentive to save money for their retirement years. This tax break benefits all Americans, regardless of income, who decide to defer use of funds to future years.
From a tax and investment perspective, the tax break for retirement contributions is a strategic tool that provides substantial savings in three ways:
- Deferring income in your high-earning years and taking out the funds in your lower-earning years (retirement) may allow you to pay substantially lower taxes.
- The “time value” of money, meaning not paying $100 in taxes today versus paying $100 in taxes 30 years from now is a substantial value.
- Deferring current income in the current year may allow you to qualify for certain tax breaks or avoid eliminated exclusions/income phase-outs for higher income earners (e.g., education credits, Roth IRA contributions, certain itemized deductions, personal exemptions and Medicare surtax).
All may not be lost, however.
Although tax breaks for retirement accounts could be scrapped, many other options may still be available. For example, a contribution to nondeductible Roth 401(k) or Roth IRA accounts are formed with after-tax contributions and, thus, do not lower current income. Essentially, Roth accounts would allow for a smaller carrot to entice Americans to still contribute to their retirement account via the ability to have these accounts grow tax-free. The benefits of these accounts are that taxes are paid when money is received and future taxes would not be paid from these accounts.
The change in vehicles simply would represent an acceleration in recognizing taxes from the federal government’s standpoint. Instead of collecting tax money many years down the road on Americans’ income, the U.S. government would receive the money up-front. The biggest loss, in my view, is the ability to adjust or manage your income, such as when people received a big bonus or unexpected income.
What would taking away one of the largest tax breaks do to Americans’ future retirement balances? The breadth of consequences would not be entirely clear to society for years to come. However, lower retirement balances would have an enormous impact on business owners, employees and community members alike. Higher retirement balances help our society systematically transition from the working to the retired phase of life.
Many desirable tax breaks are under consideration for elimination by lawmakers, so we will have to wait and see how everything turns out. Remember, every investment strategy should start with your taxes. Be sure to ask your tax advisor and financial advisor how your financial future may be impacted by new tax reform.
Phillip Mitchell, CFA, CPA, MBA is principal at Kroon & Mitchell, a tax and investment strategy firm in Grand Rapids.