Talking Tax Reform: Are 401(k) Contributions Fair Game?

President Donald Trump was quick on the Tweet button in late October, reassuring retirement savers that their pretax 401(k) contributions wouldn’t be capped at $2,400 annually in the new tax reform package.

Tax writers kept that pledge when the first bill emerged last week. But there are no guarantees in Washington, where many discarded ideas seem to return again and again.

The question for financial advisors, and their retirement-minded clients is this: should annual 401(k) contributions be capped at $2,400, or any low number?

For now, the status quo remains in place, as legislators seek to hammer out a tax deal by the end of November. Retirement savers will be able to contribute up to $18,500 to their 401(k) plans, up from $18,000 last year.

If Congress were to try and cap pretax 401(k) contributions, financial services professionals were lining up to denounce the deal.

“No, emphatically,” said Brett Anderson, financial planner with St. Croix Advisors in Hudson, Wis. “Most Americans aren’t saving enough for retirement already, and this would be another reason not to save more.

“In many cases, the cap of $18,000 a year (and) $6,000 catch-up contribution isn't high enough,” he added.

Anderson is hardly alone. Other financial industry insiders agree the pretax cap is a lousy idea, especially if a cap were to end up at $2,400.

“No limits – absolutely not,” said James Pollard, a marketing consultant who works
with financial services professionals at TheAdvisorCoach.com. “People should be able to save as much as they would like, especially figuring that the average American saves little to nothing each year.”

Investment cash is a huge driver of the economy, because it shows optimism in our future, Pollard explained.

“Capping the 401(k) is like saying you can only believe in the future of America this much,” he added.

Limited Availability

There are a limited number of employer-sponsored defined benefit plans (pensions) available as it is, said Henry Ford, principal and senior advisor for LifeSteps Financial, a registered investment advisory firm. A pretax cap would severely limit the amount of money an individual could save for retirement.

If a workplace pension provided $50,000 to $100,000 toward retirement, a person would have to supplement that pension with between $1 to $1.5 million, Ford said, just to maintain an equivalent lifestyle after retirement.

“That number would not be achievable under the $2,500 cap,” he added.

One creative approach from financial professionals is to deep-six the 401(k) “capping” model and replace it with a contribution model based on the retirement saver’s income and needs.

“The whole retirement industry has applied the wrong thinking,” said Kyle Ballard, a retired accountant specializing in taxes and retirements. “They cap the wrong amounts.”

Instead of capping the retirement fund, lawmakers should change the cap by moving it to the annual earnings of the retirement saver, Ballard said.

“Thus, you’d have some ‘stair steps,’ at, for example, $50,000, $100,000, or $200,000,” he explained. “That would give the individual a variety of choices.”

'Need to be Capped'

Still, not every money management expert disagrees with capping 401(k) pretax contributions. Some say there’s a strong case to be made to rein in those pretax dollars.

“401(k) contributions need to be capped,” said Richard M. Prinzi, Jr., CPA and co-founder of F-Sharp Tax Management Services. If they aren’t, “tax plans will include huge payments to the 401(k) for the wealthiest taxpayers, while still being difficult for the middle and working class to participate.”

The current 401(k) maximum is not restrictive, Prinzi said, as most people cannot afford to contribute the maximum or the business owners cannot meet the safe harbor requirements to add the maximum contribution.

The tax code is so complicated because the wealthiest taxpayers have the ability to change the nature of their income, he said.

“If changing income to capital gains, earned wages, rental income or any type leads to a favorable tax treatment, the affluent can make the adjustment,” he explained. “If you can avoid tax on income by converting it to earned income and contributing 100 percent into a 401(k), it would be used to drive down the average tax rate with little or no planning.”

Most of tax planning is designed to convert earned income to “other” types as they almost all have a better tax treatment, Prinzi added.

In that regard, capping 401(k) contributions at $2,400 would make the tax burden shift unfairly to the middle and working classes. It would take away one of the few tax advantages working- and middle-class employees can enjoy.

“The valuable adjustment would be to reduce the regulation in safe harbor so the owners of a business can take advantage of the max-401k contribution currently available to them,” Prinzi said, “without restricting them based on low-income employees who cannot afford to make any contributions.”

Brian O'Connell is a former Wall Street bond trader, and author of the best-selling books, The 401k Millionaire and CNBC's Guide to Creating Wealth. He's a regular contributor to major media business platforms, including CBS News, The Street.com, and Bloomberg. Brian may be contacted at [email protected]