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Should the government abolish 401(k) accounts? How to prepare in case these economists get their way

Two prominent economists recently stoked controversy by recommending that the IRS eliminate tax-deferred contributions to 401(k) accounts. Major changes are unlikely to happen anytime soon, and your savings aren’t at risk of disappearing, so don’t panic about the headlines. Still, it’s important to understand the challenges and possible solutions policymakers currently face when it comes to retirement planning. That way, you can build a solid retirement plan that can thrive regardless of future regulations.

Two economists made a bold recommendation

The American Enterprise Institute (AEI) published an article in January in which two economists advocate eliminating tax preferences on 401(k) contributions. This suggestion ruffled some feathers: These are among the most popular retirement savings tools, and Americans have about $7 trillion in these accounts. The article sparked discussion about the problems that arise and the best ways to solve them.

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It is not unusual for economists at the AEI to argue for deregulation or fiscal measures. However, this article attracted attention because it was co-authored by Alicia Munnell, a high-profile professor, along with Andrew Biggs, a senior fellow at the AEI and former deputy commissioner of the Social Security Administration. The two have publicly disagreed in the past, so this collaboration turned heads.

The article calls for a creative and drastic solution to the social security financing problem. The federal government’s guaranteed pension fund has negative cash flow and the Social Security trust is expected to be depleted by 2035. The shortage is caused by an imbalance between people who contribute and people who benefit from the system. These problems are expected to stabilize in the late 2030s, but in the meantime there is a serious threat to solvency. In the best case, the cash buffer for future generations will be exhausted, leaving no margin of safety. In all likelihood, a combination of higher payroll tax rates and lower benefits will be needed to keep Social Security benefits safe.

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Munnell and Biggs point out that 401(k) tax treatment costs the government nearly $200 billion in annual revenue. They suggest that these funds would be better served supporting the Social Security system, increasing the guaranteed income that future retirees receive.

The authors argue that the 401(k) tax treatment has not had a significant impact on the savings rate, and that the tax incentives disproportionately help high earners. They argue that tax policy has not achieved its intended goals, and that regulators must work to address the widespread shortage of retirement savings before it turns into a national crisis.

To be clear, this is not a proposal to take away your existing 401(k) assets. If implemented, there will be no immediate tax assessment or clawback of previous contributions. In fact, it is unlikely that this policy will be adopted at all. The authors probably know that, and the true intention of the article could be to open new doors in the public debate about a serious problem that remains unresolved.

Why this may be important

There are no major changes coming in the near future, but savvy financial planners will recognize some of the ideas that are gaining traction. It is widely accepted that future policy changes will be necessary, even if those changes are relatively modest. This article serves as a warning of a possible solution that could be implemented in the next decade or two.

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Munnell and Biggs’ conclusions and recommendations are somewhat radical, and have certainly drawn resistance from fellow economists, lawmakers and public figures. There is strong resistance among economists to eliminating a popular tax break, limiting personal control over retirement savings and funneling extra money into a welfare system that many academics consider poorly managed.

However, the dual nature of the article is remarkable. Legislation is more likely to be implemented with broader support, especially when it comes to a partisan issue like taxes and the redistribution of wealth. People on both sides of the aisle have reasons to support this, and that gives it some traction. When legislation is eventually passed, it may be influenced by some of the ideas being proposed today.

What it means for your pension plan

If you are currently using a 401(k), continue to do so. Most financial planners support 401(k) contributions at least up to the maximum contribution provided by your employer, provided it does not otherwise put undue strain on your financial plan. Most people benefit by deferring taxes until retirement, when they are in a lower bracket. If that benefit is in danger of being revoked, it’s probably a good idea to take full advantage of it during your peak earning years.

Earners in high tax brackets should also consider making contributions to traditional IRAs, which receive the same treatment as a traditional 401(k). The deductible amount may be limited by your 401(k) participation or income, but many households can still participate in these accounts.

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The new proposals also serve as a reminder that you can save for retirement outside of tax-deferred accounts. Roth IRAs are great tools for growth investing because they eliminate any tax on returns. You can also build wealth by investing in investment accounts. These won’t provide meaningful tax benefits, but they do provide liquidity and flexibility not available with other retirement accounts.

Finally, this is also a stark reminder of the threats to Social Security. Future generations will almost certainly receive Social Security benefits, but they may cover less of the average household budget than they do today. Being self-sufficient is always preferable, so you should aim to save at least 15% of your annual income. Spreading these savings across multiple investment accounts is a great way to give you options when you need to withdraw money to meet cash needs.

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Should the government abolish 401(k) accounts? How to Prepare in Case These Economists Get Their Way was originally published by The Motley Fool

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