Status quo bias is one of the most powerful forces in American political life, and to overcome it a party or faction usually requires some combination of internal unity, lobbyist and interest group solidarity, and, if push comes to shove, popular support among the voters they’re ostensibly in Washington to represent.
The current Republican push for “tax reform” does not appear to enjoy any of the above pillars of support, so I would very slightly shade the odds against the passage of a tax reform bill this year (no, I’m not taking bets, I got burned once already last November). Nonetheless, what has been truly remarkable to watch is the interest groups coming out of the woodwork to defend the most indefensible parts of the current tax code. Even worse has been seeing their arguments passed along by journalists as if they were objective observers making good faith arguments, and not just folks trying to protect their own interests by any means necessary.
I follow the financial press closely enough to see, in the last few weeks, an outpouring of handwringing about the briefly-mooted suggestion that Republicans would drastically reduce the amount of pre-tax payroll that could be contributed by employees to 401(k) plans. The only problem with this proposal is that it doesn’t go far enough: 401(k) plans are a plague, and getting rid of them completely can’t come soon enough, within or without the context of tax reform.
Giving employer-sponsored benefits tax privileges is bad
While this argument has traditionally focused on the exemption of employer-based health insurance plans from taxable income, it’s equally relevant to retirement savings programs. I don’t have an objection to employer-based retirement savings programs any more than I have objections to employer-based health insurance programs.
My objection is to privileging such programs in the tax code, leaving the employees of organizations which do not sponsor retirement or health insurance schemes, and the self-employed, with the duty to pick up the tax burden avoided by those firms that do so.
Employers are not good at administering 401(k) programs
The quality of the 401(k) programs administered by employers varies both qualitatively and quantitatively:
- Employers hire different management firms with access to different fund families with different cost structures;
- Employers accept kickbacks from investment management firms because, due to a legislative drafting fluke in ERISA, only fund management, not fund selection, decisions are required to be made with employees’ best interests in mind;
- Employers have different plan rules, with some allowing and some disallowing loans, some allowing and some disallowing in-service rollovers, etc.
Even if you believe that savings by workers during their careers is essential to retirement security when they stop working, why would you put this responsibility in the hands of employers who have no interest or demonstrated ability to fulfill it?
And what would you do about those employers who have no interest in even trying to fulfill it?
Brief aside: my favorite episode of 401(k) apologetics
The genre of 401(k) apologetics is diverse and beautiful, but I have to point out my single favorite entry in the genre. MarketWatch recently published the following passage without a trace of embarrassment:
“This year, the maximum pre-tax contributions an employee can make to a 401(k) plan is $18,000, and next year will be $18,500. (Some plans allow for additional after-tax dollars to be contributed as well). But it would be nice for employees if these contributions were even higher, said Rose Swanger, a financial adviser at Advise Financial in Knoxville, Tenn. Only about 10% of Vanguard participants maxed out their 401(k) contributions in 2016, according to an analysis by the Center for Retirement Research at Boston College, down from 12% in 2013, but the option could be encouraging for people who do not understand the scope of how much they need for their retirements [emphasis mine].”
Did you follow the logic here? Since only 10% of employees maximize their contributions, therefore the contribution limit should be raised, giving employees a more poignant sense of falling behind their retirement savings goal. Or something like that.
Of course the increased limit would be a direct subsidy to those high-income employees who do currently and would under any contribution limit regime maximize their pretax contributions, paid for by employees who do not take advantage of or have access to pretax retirement savings vehicles.
The solution isn’t a secret, you just won’t personally like it
The most interesting thing about 401(k) plans is that you, if you participate in one, probably think they’re the key to securing a dignified retirement in the 21st century. But you’re wrong. There is no source of data which suggests people need or use 401(k) accounts in order to finance a dignified retirement.
401(k) accounts are used by a small minority of wealthy individuals to shield income and capital gains from taxation during their lives in order to maximize the amount of wealth they leave to their heirs.
Just as with the use of 529 college savings accounts for higher education expenses, you’re allowed to use 401(k) plans for retirement savings, but that’s not how they are actually used by wealthy families trying to shield as much income as possible from taxation.
The solution is easy: eliminate preferences for employer-based retirement savings accounts. Increase individual retirement account contribution limits. Enforce strict quality and fiduciary standards on retirement account advisors.
But you don’t want the easy solution because you don’t want a solution at all: you want to shield as much of your earned income and capital income from taxation as possible, to leave as much as possible to your heirs. So, at least for now, we muddle along.
No heir for me so when I’m early retiring and declaring FI within a few years it will be a combo of conversion from IRA to Roth during low income years as well as 72 T that will keep me going for many many years. I have not been making big money but have used 401k and IRA diligently exactly as the tax code allowed me. Whatever happens next I don’t know. But thanks whoever so much for having had the opportunity.
AlwaysFlying,
Congrats! To be clear, I never begrudge anyone doing whatever the tax code allows them to do to shield their income from taxes. My problem is when people fight to defend our broken tax system just because they, personally, benefit from it.
People should be able to separate “I will do this as long as it is legal” from “this should be legal,” but they’re too often blinded by self-interest.
—Indy
The fees on some programs are so high you just want to change jobs to roll it into an IRA. Simply higher limits would give small businesses a more level playing field with large employers too. It’s a big deal (and high cost) for a 50 person company to start providing these benefits.
The little employer matching does encourage sign-ups. The tough thing is how to nudge people into savings if employers are not getting into the retirement benefit game.
So are you suggesting that we just lower the limits to tax deferred accounts to avoid their use as estate planning tools? Don’t know how much it matters if the estate tax is one of the few taxes being reformed.
Forte,
That is correct, I do not believe tax-deferred accounts should exist, whether for retirement, education, health care, or any other designated expense, since in reality such accounts will be used overwhelmingly by the wealthy to permanently shield their income from taxation. All income should be taxed in the year it is received. I do believe it is reasonable for a modest amount of post-tax income to be allowed to be set aside in Roth-style individual accounts (i.e. not employer-sponsored so completely portable).
The estate tax is not, strictly speaking, the most important issue, since if income can be set aside pre-tax and compound untaxed then the overwhelming majority of the tax dodge has already been executed. Whether or not a small percentage of it is subjected to a small estate tax at death doesn’t matter as much.
—Indy
Disagree. My mother was one of the last people I know to get a pension, and it was only enough because they gave her extra for early retirement.
Given the current environment, 401k contributions are the only way to go.
El Ingeniero,
It’s good that your mother got a pension, and I’m glad it was enough for her to retire on. In order to secure the same dignified retirement your mother enjoyed, we should provide adequate pensions to all retirees, for example by increasing Social Security benefits to make up for the long-term disappearance of defined-benefit programs.
One way we could pay for expanded Social Security benefits is by eliminating 401(k)’s and taxing income in the year it’s earned.
—Indy
Probably don’t need one. But if you can fund one at all, it helps. A lot.
Anything to encorage people to save is good!
Larry,
Why?
—Indy