Limiting 401(k) tax advantage is unwise

President Barack Obama’s budget proposal, which would end tax deferral of contributions to individual retirement accounts when they accumulated $3.4 million in assets, sounds reasonable on the surface, but it raises many concerns.

Among them: Has anyone in the administration considered the possible impact on employer support for 401(k) plans if the tax deferral of contributions to 401(k)s and IRAs is limited to those accounts with $3.4 million in assets or less?

Mr. Obama and his advisers should examine the history of defined-benefit plans, which have almost disappeared in the private sector. One trigger for the decline in DB plans was legislation passed in 1987 that capped the maximum salary on which a tax-exempt pension benefit could be based at $235,800 per year.

The immediate result was a surge in DB pension plan terminations as top executives realized that they would get little benefit from the company pension plan, which was a large corporate cost and an administrative nightmare.

WHY BOTHER?

Many top executives apparently asked: Why bother with the hassle of a pension plan, with all its legal exposure through the Employee Retirement Income Security Act of 1974, when I will get little from it?

Terminations surged again in 1990 when the salary on which a tax-deferred DB pension could be based was reduced further to $150,000 a year (it is now $205,000 a year).

Many companies replaced their DB plans with 401(k) plans for most employees, supplemented with nonqualified pension plans for highly paid executives.

Mr. Obama now proposes to limit the account sizes of 401(k)s for the highly compensated. It is possible that senior executives, seeing their retirement income from tax-deferred plans limited, would stop supporting 401(k) plans.

The dollar limit actually could be less than $3.4 million, as it would be based on the amount needed at retirement to buy an annuity of $205,000 a year.

As an analysis by the Employee Benefit Research Institute shows, the cost of such an annuity depends on the discount rate. If the limit had been in force in 2006, the threshold could have been as low as $2.2 million.

Mr. Obama apparently has aimed this limit at the top 1% of income earners, one of his favorite targets, but an EBRI analysis suggests that he could hit a much larger group.

The analysis shows that at the end of 2011, less than 1% of participants in 401(k) plans would have been affected by the proposed $3.4 million limit.

However, if the limit were $2.2 million, almost 3% of accounts would be affected.

EBRI also noted that about 6% of workers 26 to 35 would be affected by age 65 if the contribution limit were as low as $2.2 million.

In a higher-interest-rate environment, an even greater percentage of 401(k) participants would be hit. That limit would hit not just corporate titans and hedge fund barons but successful owners of small and midsize businesses.

COLLATERAL DAMAGE

The limit also could cause collateral damage to the economy if employers and highly compensated employees cut their support for 401(k) plans and changed their own spending, saving and investing habits.

As the old saying goes, if you tax something, you get less of it.

The $3.4 million limit would be an increase in taxes on saving above that level, so the likely result would be less saving, and ultimately less investment in the private sector. This wouldn’t be good for the economy in the long run.

Further, the limit might increase federal tax receipts but would depress them later because taxes forgone on 401(k) plan contributions during the accumulation phase are paid by retirees as they draw on those savings in retirement. This would be worsened to the extent that high earners shift savings to Roth IRAs, which pay taxes now but don’t pay taxes in the future.

Mr. Obama’s plan thus would borrow tax revenue from the future, leaving a hole to be filled by some future Congress.

The Obama plan is flawed, but while it is unlikely to pass through Congress in the coming debates over the budget, it might have opened the door to future assaults on the nation’s non-federal retirement system, creating uncertainty about the rules. That might be its most damaging effect.