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A Lower 401(k) Limit Will Be Terrible for Retirement Savers

President Donald Trump and Senate Republicans are set to unveil their highly anticipated tax overhaul today, and the plan is expected to feature steep tax cuts for the wealthy and corporations.

But the plan also might include a troubling, borderline unfathomable change to section 401(k) of the tax code — the part that allows employees to put a portion of their income in a tax-deferred savings account. 401(k) accounts are “the most common employer-sponsored retirement plans” in the workforce and are popular for their tax savings. Currently, employees are allowed to contribute up to $18,000 a year into their tax-deferred 401(k)s. But Republicans are reportedly considering reducing that limit to $2,400 a year.

Remarkably, there are already people claiming that this change might, in fact, help people better save for retirement. That’s a profoundly idiotic interpretation of the news and is mostly based on a flawed economic study from researchers at the Harvard Business School. The study finds that people who contribute to a post-tax (i.e., Roth) 401(k) retirement account have more earning power upon retirement than people who choose the traditional pre-tax 401(k) account.

John Beshears, the lead author on the study, recently explained his position to the Wall Street Journal:

If a worker saves $5,000 a year in a 401(k) for 40 years and earns 5 percent return a year, the final balance will be more than $600,000. 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 percent in retirement. That makes for a difference of $120,000 in spending power, which a life annuity will translate into about $700 a month in extra spending.

The study’s elemental flaw, however, is that it assumes people will put the same amount of money in a retirement account regardless of whether it’s a post-tax Roth account or a traditional pre-tax 401(k).

I’m here to tell you that the latter — a tax-deferred account — is the superior retirement savings device, and that anyone who interprets this study as an argument for a Roth account is indeed misinterpreting it. Paying $5,000 post-tax isn’t the same as paying $5,000 pre-tax. Those numbers aren’t equivalent, because you’re not paying taxes on the second amount.

Let’s look at this using a more concrete hypothetical. Better still, we’ll use the same $5,000 figure as the Harvard study.

Suppose the tax rate is 20 percent. Putting $5,000 in a post-tax retirement account means you started with $6,250, paid $1,250 in taxes and then put the remaining amount toward retirement.

Someone with a pre-tax account could put the entire initial amount, all $6,250 of it, into their 401(k) account,.

For one, the extra $1,250 in this scenario will be able to sit in a savings account for years — decades, even! — where it will accrue interest and interest on that interest. And so, by the time the person is retired, he will have generated some serious cash:

  • Supposing a modest 5 percent rate of return, a 401(k) with $6,250 in it will be worth more than $27,000 after 30 years — and that’s if the person never contributes another cent to it.
  • The person who put $5,000 in a post-tax account, however, would have just $21,610 after 30 years — $5,000 less than the person who availed themselves of the tax deferral.

Dissenters will likely point out that the person who saves $6,250 will have to pay 20 percent in taxes when he withdraws the money years later, and that he will end up with nominally the same amount of money as the person who paid those taxes up front.

Again, this argument neglects to include important financial information (such as how taxes work) and totally misses the point of using a tax-deferred 401(k).

The real reason 401(k)s are so useful is because most people tend to get taxed at a lower rate in retirement:

  • Take that initial $6,250. And again, suppose the person who earned it is in the (totally hypothetical) 20 percent tax bracket. If they pay the taxes up front, they have $5,000 to put toward retirement.
  • Now let’s say they take that $6,250 and put in a tax-deferred 401(k). By the time they’re 65 and retired, they’ll be in a lower 15 percent tax bracket (because, you know, they’re retired, and no longer working and earning a large income). If they pull out all of that money — and pay 15 percent on it, instead of 20 — they will have $5,312.50, or an extra $312.50. And that’s supposing zero gains in interest.

These pre-tax savings are the entire point of a 401(k) savings account. It’s how the “savings” part of the savings is actually generated. Otherwise, a 401(k) would lose all value, and there’d be no real point in using one.

If people want to take their post-tax income and put it in a savings account, they can already go ahead and do so. They don’t need a special financial instrument to make it happen. You can try it right now, in fact! Just go to the bank with whatever spare cash you have on hand and ask to open a savings account. They will gladly take your business.

This all seems like it would be painfully obvious. So obvious that I feel like I’m being redundant. But there are journalists — self-proclaimed personal finance experts, no less — who are breathlessly carrying the GOP’s water and saying a lower limit on pre-tax 401(k) contributions won’t hurt people’s saving prospects. Heck, a lower limit will actually help people save more, they say!

But the argument for a lower limit is cynical and supposes that the average salary-earner doesn’t understand the enormous advantages of pre-tax retirement savings.

Sadly, these “experts” do have a point— the U.S. tax code is complicated, to the point most people never even try to understand it. The people surveyed in the Harvard study certainly don’t seem to understand that they could afford to be putting more money in a tax-deferred 401(k), precisely because the taxes are deferred. But that doesn’t mean we should be reinforcing these bad savings habits.

Tax-deferred savings is smart and good. Use it—and hope we don’t lose it.