Dan Caplinger

The Motley Fool

President Donald Trump was elected, in part, because of his championing of income tax reform, with promises of a simplified structure of tax rates for individuals and lower tax rates on corporations. Yet at no time during the campaign did the president signal that the way his administration would pay for those moves would involve taking away one of the most popular and widely used tax breaks in the income tax system.

Now, though, lawmakers are reportedly looking at removing the upfront tax deduction for traditional 401(k) contributions, and some proposals have even suggested taking away part of the tax deferral that 401(k) plans provide. With most Americans already saving an inadequate amount toward their retirement, changes to the rules would only take away a key incentive for setting money aside for the future and punish those who prudently plan for their retirement.

How Congress might change your 401(k)

One big problem involved in corporate tax reform is that it would be costly. Cutting tax rates from 35% to 15% would result in a drop in revenue, and many lawmakers want to ensure that any tax reform legislation is revenue-neutral. To achieve that, Congress would have to couple tax cuts with ways of raising revenue.

One of the largest tax benefits Americans get comes from the exclusion from income of money that they save in 401(k) plans. According to the latest report from the Joint Committee on Taxation, the exclusion of contributions to and earnings of defined contribution plans cost the federal government more than $90 billion in potential tax revenue in 2016. Estimates have that number rising to $146 billion by 2020, and the total over the five-year period from 2016 to 2020 is almost $584 billion.

The key proposal Congress is reportedly looking at treats all 401(k) contributions as if they were Roth contributions. That would take away upfront tax benefits in exchange for making earnings and appreciation tax-free going forward. By doing so, the federal government believes it could raise $1.5 trillion in additional tax revenue over the next decade, providing an ample source of funding for tax cuts elsewhere.

An even bigger threat could come from measures to change the tax-deferred nature of 401(k)s. Right now, any income and gains your 401(k) generates don't get taxed until you make withdrawals. But one proposal would impose a 15% tax on annual gains within 401(k) plans. For long-term stock investors, that could put 401(k) plans at a disadvantage to simple taxable accounts, where one can defer capital gains tax simply by not selling shares. Proponents of the measure suggest that the move would raise between $48 billion and $60 billion in annual tax revenue between 2018 and 2025.

Why would President Trump raise taxes?

After all the talk of tax cuts during the campaign, it seems like a complete about-face to be talking about tax increases. However, the justification some lawmakers have come up with involves the potential impact on investment values that could come from corporate tax reform. As the argument goes, if taxes on corporate income go down, then there would be an immediate increase in after-tax earnings, which in turn should produce a rise in share prices. For the government to impose a tax on that share-price increase is, in effect, a way to balance out the tax-created bump.

However, the fact that Republican lawmakers are even contemplating such measures comes as a shock to those who have followed the political pendulum swing over time. For years, it has been Democrats who have looked at 401(k)s as a source of tax inequity, and Democratic presidential candidate Hillary Clinton suggested reducing the value of tax deductions for high-income earners on their 401(k) contributions. Budgets from former President Barack Obama included provisions that would have limited 401(k) savings for the wealthy, and some policymakers have even suggested that 401(k)s should be abolished entirely. In that light, for attacks on 401(k)s to come from the other side of the aisle shows how the world in Washington has once again turned upside down.

Still, the key question is how much of President Trump's base of loyal supporters truly cares about 401(k) tax breaks. For those who face unemployment and economic hardship, huge deductions for retirement savings are just one more sign of how income inequality can compound because of tax policy. If you have modest incomes and pay low tax rates, then a Roth-style 401(k) is often a better option over the long run -- as long as Roth accounts remain truly tax-free and don't also end up on the chopping block in Congress' search for revenue.

What to do?

You can expect more details on President Trump's tax plan this week, but it's not too soon to let your lawmakers know that 401(k) deductions are an important component of your retirement savings strategy. Changing the rules on retirement savers when it's too late for them to adjust accordingly is unfair, no matter which side of the aisle is behind such a measure, and urging lawmakers to respect past planning is essential in order to keep America's retirement savings problem from getting even worse.

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