A future without 401(k)s? Advisors don’t like that one bit

Andrew Herzog of The Watchman Group and Catherine Valega of Green Bee Advisory

401(k) accounts encourage workers to save, and changing the tax preferences could have a deleterious effect on retirement investing, advisors say.

There has been a lot of discussion about the fate of the 401(k) system in the month since a pair of academics proposed killing the tax preferences for 401(k)s to help shore up Social Security.

It wasn’t the first time that the idea of reaping tax revenues early from the retirement plans has been explored – members of Congress have discussed it. But past proposals to shift 401(k)s to an exclusive Roth-style tax treatment would simply move government revenues from the future to the present – a one-time event that conveniently fits with the 10-year budgetary window that Congress considers.

The newer pitch would go further, though. In their paper last month, Boston College’s Alicia Munnell and the American Enterprise Institute’s Andrew Biggs gave more options to reduce the tax benefits of the 401(k) system, including eliminating the tax-free growth of account assets and the perks for employers that offer plans.

The pair noted that the defined-contribution savings system has primarily benefited affluent workers who would very likely save and invest for retirement through other avenues in the absence of 401(k)s.

In a response posted on Bloomberg this week, Manhattan Institute senior fellow Allison Schrager predicted that the 401(k) structure will be dead within 10 years.

InvestmentNews asked numerous financial advisors for their thoughts on what the demise of the 401(k) would mean.

Unvaryingly, their written comments showed they’re not keen on changing the system.

“This is the most ridiculous idea I’ve ever heard of. People often tend to care more about taxes (and reducing them) than anything else. Thus, when they contribute to their 401k to reduce their taxable income, they are also saving for their future retirement – which is good for the country unless we want more people living an impoverished retirement,” said Catherine Valega, wealth consultant at Green Bee Advisory. “I think there is no chance this makes it any further.”

Even if changes to 401(k) tax treatment could help shore up Social Security, getting Congress to go along with that would be difficult, said Andrew Herzog, associate wealth manager at The Watchman Group. “Changing the tax treatment will absolutely obliterate retirement savings for most Americans. Employers are motivated to offer retirement plans for several reasons, but certainly one of them is getting tax deductions on their income tax return via employer contributions.

“A huge benefit of tax-deferred accounts, like the 401(k), was tax-free activity within the account on a yearly basis. People can trade and realize gains and income all year and avoid paying taxes, unlike a standard taxable brokerage account, until withdrawals,” Herzog said. “This feature of compounding returns, free of a tax drag, really showed people how their retirement account can grow over the decades and motivated many to save.”

Another advisor, Carla Adams of Ametrine Wealth, said that she worries that changes to the 401(k) system would discourage non-affluent workers from participating or provide them with easier access to their assets before retirement.

“The rich will be fine either way, but the majority of workers have little to no savings outside of their 401(k) plan,” Adams said. “The beauty of the 401(k) plan is that the money comes right out of your paycheck, so it never hits your bank account. Even the most well-intentioned people have trouble setting aside money once it hits their bank account, even if they have gotten by just fine previously with the money being taken out of their paychecks.”

Additionally, switching to a Roth-only model could discourage the middle class from saving and investing, said DJ Hunt, senior financial advisor at Moisand Fitzgerald Tamayo.

“Low-income workers are likely already contributing on a Roth basis, so they won’t see a difference in their paychecks. Middle income earners, on the other hand, may currently be doing pre-tax contributions and will absolutely notice the smaller paychecks, should they be forced to change to Roth. This could cause them to lower their contributions,” Hunt said. “In addition, the Secure Act 2.0 heavily favors Roth accounts in several different ways. This could be a telegraph of [Congress’] ultimate intentions.”

However, Daniel Galli, principal at Daniel J. Galli & Associates, argued that the tax benefits of 401(k)s are not their main selling point. The biggest benefit for workers is the payroll deduction, which has provided discipline to help people save, he said. The employer matching contributions are the next most important, he noted.

“If the employer doesn’t get a reprieve from FICA and taxes on these, they may not see the value in continuing to make them. The tax advantages come next, with the choice of pre-tax to help lower taxes now or Roth to provide potential tax-free income in retirement,” Galli said. “We shouldn’t be talking about getting rid of these plans. We should be talking about how to increase participation to increase savings.”