401(k) Tax Changes May Be On Fast Track

WASHINGTON D.C. (TheStreet) -- In the coming weeks, Americans could face sweeping changes to the tax deferral status and funding strategies of their retirement plans.

The Senate Finance Committee last week held a hearing (a webcast and testimony can be found here) to discuss proposals for strengthening the nation's retirement system as well as dealing with the reality that these plans are a ripe target for deficit reduction plans.

A rethinking the tax structure of 401(k) and IRA plans could be included in Congress' deficit reduction proposals due in December.

As officials in Washington grapple with debt reduction and the need for increased revenue, rethinking the tax structure of 401(k) and IRA plans has come under consideration and could be included in deficit reduction proposals due in December.

"All of the reforms I read about lately seem directed toward reducing the amount of money that people may set aside in defined contribution plans and IRAs," U.S. Senator Orrin Hatch, R-Utah, ranking member of the Senate Finance Committee, says in his remarks. "For example, the National Commission on Fiscal Responsibility recommended capping pretax contributions at $20,000. The Congressional Budget Office describes a proposal to reduce annual contributions to 401(k)-type plans by $7,650 for older workers, largely by repealing the ability of workers at age 50 to begin making catch-up contributions. IRA contributions also would be cut by $1,500 for older individuals."

"Many of these proposals are offered in the name of greater progressivity in the tax code, and helping lower-wage workers," he added. "But this just doesn't make sense. Trying to help lower-wage workers save for retirement by reducing the 401(k) and IRA contribution limits is like trying to cure a headache with a guillotine. The cure is worse than the disease. I am concerned that if these proposals were adopted many employers will throw up their hands in disgust and just drop their plans."

Currently, individuals can contribute up to $16,500 a year pretax, or tax deferred. The total amount that can be contributed combining employee and employer contributions is 100% of the worker's compensation or $49,000, whichever is less. Tax-deferred contributions to IRA accounts are limited to $5,000 a year.

One of the notable proposals pitched during the hearing would would convert the current deduction to a flat tax credit.

"The purpose of the retirement income system is to promote an adequate retirement, not to promote tax sheltering through 401(k)s," testified William Gale, a co-director of the Urban-Brookings Tax Policy Center at the Brookings Institution.

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