- Republicans are reportedly considering capping pre-tax 401(k) contributions as part of President Donald Trump’s tax plan.
- But two-thirds of Americans don’t even contribute to a traditional 401(k) currently — and the ones who do aren’t close to maxing it out.
- Additional savings could be directed toward a Roth 401(k), which could actually leave the majority of Americans better off in retirement.
There’s a lot of hoopla surrounding President Trump’s new tax plan, which is reportedly considering capping pre-tax 401(k) contributions at $US2,400 a year, a far cry from the current maximum contribution of $US18,000 for 2017, and $US18,500 for 2018.
But the reality is this: Two-thirds of Americans aren’t even saving money in a 401(k), let alone maxing out their contributions each year.
In fact, according to data from Vanguard, just 4% of people earning below $US50,000 a year max out their 401(k) at the current limits, and 11% of people who make between $US50,000 and $US100,000 do. People making over $US100,000 are the most likely to max out their 401(k), perhaps unsurprisingly, with 32% making the highest allowable contribution.
In some versions of the rumoured tax proposal, additional retirement savings would still be possible, but would be directed to a post-tax Roth 401(k) instead, reports Business Insider’s Lauren Lyons Cole.
Roth 401(k) contributions are deducted from your paycheck, just like traditional 401(k) contributions. Both types of accounts share the same maximum contribution and investment options. The only difference is when you pay taxes.
Saving in a traditional 401(k) is cheaper today because it allows you to postpone paying taxes until you begin taking withdrawals in retirement. That’s one reason financial professionals like the account so much — theoretically, people will put more money into the account if it takes less of their paycheck to do so.
And yet, only 41% of workers are saving in a 401(k) at the 79% of American companies that offer a plan to employees, Bloomberg reported earlier this year.
Roth 401(k) contributions are deducted from your paycheck as well, but the amount is funded with your take-home pay instead. Meaning, for every $US1,000 you save for retirement, you’ll have to fork over $US200 or so to the IRS $US200, depending on your tax bracket.
But Harvard researchers found that most people don’t think about taxes when deciding how much to save for retirement. The majority of Americans just pick an amount — or in the case of auto-enrollment, employers pick an amount — and start saving. That could be 10% of income, for example, or $US50 per paycheck.
Although it’s more expensive to save in a Roth 401(k) today, those who use the account will likely end up better off in retirement, according to John Beshears, the lead author of the Harvard study and a behavioural economist and assistant professor of business administration at Harvard Business School.
Beshears explained his research to the Wall Street Journal earlier this year:
“If a worker saves $US5,000 a year in a 401(k) for 40 years and earns 5% return a year, the final balance will be more than $US600,000. If the 401(k) is a Roth, the full balance is available for retirement spending. If the 401(k) is a traditional one, taxes are due on the balance. Let’s say the person’s tax rate is 20% in retirement. That makes for a difference of $US120,000 in spending power, which a life annuity will translate into about $US700 a month in extra spending.”
A Roth 401(k) isn’t always better financially — for example, if you work in a high-tax state now but plan to retire in a lower-tax state in the future — but for the majority of Americans, the Harvard study shows a Roth 401(k) leads to increased spending power in retirement.
Additional reporting by Lauren Lyons Cole.