So, first Sean Spicer announced earlier today that the White House may eliminate the 401(k) tax preference in favor of an expanded standard deduction.
Then the White House announced it meant none of this and that the 401(k) preference is perfectly safe. So far, so normal. The left hand doesn't know what its own thumb (never mind the right hand) is doing and no such tax reform will likely happen.
Now let's move on to the interesting part: that's a shame, because this isn't actually a terrible idea.
Eliminating the 401(k) tax preference in favor of an expanded standard deduction would be expensive and complicated, but also a surprisingly egalitarian move on the part of an overwhelmingly plutocratic Republican Washington. It would help mid- and low-income taxpayers while at the same time reaching a very large segment of Americans.
The 401(k) tax preference reduces an employee's taxable income by the amount of money he pays into a qualifying retirement account. This is not an itemized deduction. It happens automatically on the W-2, meaning that everyone gets it even if he uses the standard deduction.
The goal is to make it easier to save for retirement, but this program often preferences the better-off. Taxpayers who make enough money to take advantage of the full $18,000 contribution limit ($24,000 for workers over the age of 50) get the most out of 401(k) deductions. Those who make less money will get correspondingly less out of this.
Meanwhile, entrepreneurs, employees without a 401(k) and the self-employed all have to make do with the more confusing and stingier set of IRA deductions.
In other words, for all its popularity, a lot of Americans get left out of the 401(k) experiment, and many more only collect on a fraction of its benefits.
On the other hand, an overwhelming majority of us get the standard deduction. Nearly 70% of Americans take the standard deduction instead of itemizing their taxes, making it one of the single best ways to help the most people at the same time.
Ending the 401(k) preference in favor of an expanded standard deduction would, at a stroke, massively expand the footprint of this tax benefit. All employees with income would get to take advantage of it regardless of who they work for, and people who earn less would receive proportionately more back relative to their paycheck. As we noted, recently, given how much new job creation has focused on service and retail, sectors with low pay and rare employer-sponsored retirement plans, this could help a lot of Americans.
For better or worse, this would also serve as a wealth-transfer mechanism.
The taxpayers most likely to itemize are also generally the wealthiest. They would lose out on the expanded standard deduction while not getting any additional tax breaks in return unless a new 401(k) preference were moved below the line. While not necessarily a morally virtuous position, it would certainly help pay for what may prove to be a very expensive tax cut.
Because this would cost.
The average 401(k) tax contribution is over $1,800 per filer per year and, as noted above, the maximum can go as high as $24,000 per person. While some people put little or nothing into their accounts, many people do make substantial contributions over the year. Keeping the IRS whole would require either expanding the standard deduction by quite a lot or introducing new complexity.
Something would have to be figured out because, as America nears what many experts consider to be a retirement crisis, now is not the time to start making it harder to save.
After all, axing the 401(k) preference while bumping the standard deduction by a few hundred dollars wouldn't cut it. For taxpayers of all stripes to see real benefit, the increase would have to approximate real, annual retirement savings. That's a lot of money and uncertainty, especially given the administration's as-yet-uncertain plans to reform the income tax code.
"Tell me what the marginal tax rate is going to be and how high it goes up and what the brackets are," said Lance Mitchell, Research Director for First Franklin Financial. "Because that's a big part of the conversation."
And, he said, the government should consider the impact of Roth IRAs, which allow retirees to withdraw money tax free. By investing with pre-tax money thanks to the standard deduction and withdrawing it equally tax-free, seniors could retire off money that the IRS never touches.
"If you could not deduct a 401(k) contribution," he said, "what would come into play is the Roth IRA… I think that those would become powerful."
"But," he added, "I don't think that they would be getting rid of the 401(k) deductions."
All in all, it would be complicated.
That doesn't necessarily make it a bad idea.
Expanding the standard deduction as a retirement vehicle would make life harder for many Americans, especially those who make enough to take full advantage of their 401(k)s. At the same time, however, it would also address the fact that millions of Americans get left out of the 401(k) experiment altogether.
For them this idea actually offers the rough outline of real, practical help with retirement planning.
It's kind of too bad this one is a nonstarter.