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.

"Not only do the existing tax rules provide less immediate benefit to low- and middle-income households, they are also relatively ineffective at inducing new saving," he says. "Contributions by high-income households to tax-subsidized retirement accounts are more likely to represent funds that are reshuffled from existing savings to take advantage of the tax benefit rather than a net new addition to saving. In other words, the current tax incentives to increase saving have relatively low bang for the buck because they merely subsidize shifting saving for high-income households rather than raising the total amount of saving in the economy."

Gale's proposal would enact a flat-rate refundable credit (of either 18% or 30%) that would be deposited directly into the saver's account. Balances would still owe no taxes until withdrawn.

Gale cited the Tax Policy Center's estimate that the immediate, direct revenue loss associated with contributions to IRAs and 401(k) plans will exceed $1 trillion over the next decade. Converting current deductions to a tax credit worth 18% of a taxpayer's retirement saving contributions would raise more than $450 billion in revenues over the next decade relative to current law, he says.

Workers' and firms' contributions to employer-based 401(k) accounts would no longer be excluded from income subject to taxation, contributions to IRAs would no longer be tax-deductible, and any employer contributions to a 401(k) plan would be treated as taxable income to the employee (just as current wages are). All qualified employer and employee contributions would be eligible for a flat-rate refundable tax credit given to the employee.

"The credit would be deposited directly into the retirement saving account, as opposed to the current deduction, which simply results in a lower tax payment than otherwise," Gale says. "Everything else would stay as is. Contribution limits would not change. Earnings in 401(k) plans and IRAs would continue to accrue tax-free, and withdrawals from the accounts would continue to be taxed as income. The Saver's Credit would continue to exist in its current form. Catch-up provisions, for workers aged 50 and older, would continue to apply. Roth plans and defined-benefit plans would be unchanged."

In an alternative version of Gale's proposal, a 30% credit would be revenue-neutral for the next decade relative to current law.

Among those speaking out against proposed tax changes was Judy Miller, director of retirement policy for the Society of Pension Professionals and Actuaries.

"Proposals currently under discussion -- slashing the contribution limits, or turning the current year's exclusion into a credit -- would discourage small-business owners from setting up or maintaining a workplace retirement plan," she says. "This is the exact opposite of what needs to be done. Data clearly show the primary factor in determining whether or not a worker is saving for retirement is whether or not they have a retirement plan at work. When evaluating any current retirement policy proposal the critical question this committee must ask is: 'Will it improve access to workplace retirement savings?'"

She says that the "flawed proposals" under consideration "are based on some persistent myths," one of them being that incentives for retirement savings amount to tax expenditures.

"Unlike deductions for mortgage interest or charitable contributions, which are permanent deductions, the incentives for retirement savings are just a deferral," he says. "Contributions -- and earnings -- are taxed at ordinary income rates when distributed from the plan. The truth is, the revenue you think you gained in the budget window from cutting retirement savings is an illusion. Reduced contributions today mean lower revenue outside the budget window, when there will be less retirement savings to be withdrawn and taxed."

She also challenged the assumption that "re-engineering the tax incentive will lead more workers to save on their own."

"Truth is, the only way we have ever gotten working Americans to save for retirement is through employer-sponsored retirement plans," she says. "Over 70% of workers making $30,000 to $50,000 contribute when covered by a plan at work. By comparison, less than 5% of workers at the same income levels save on their own in an IRA when there is no workplace plan."

"Given the existing pressures on Social Security, this is not the time for a massive experiment with workers' 401(k) plans," she added. "We need a tune-up not an overhaul. The key to promoting retirement security is expanded workplace savings, and reduced incentives for small-business owners to sponsor retirement plans would be a big step in the wrong direction."

Laurie Nordquist, executive vice president at

Wells Fargo

(WFC) - Get Report

Institutional Retirement and Trust, has been watching the debate closely. She worries that big changes could take many plan participants by surprise.

"I think it is good the dialogues are starting and I hope they continue at a pretty fast pace. With the December date lurking out there for looking at some of the tax changes, we are really at a critical juncture where the retirement plans could in fact be one of the targets in terms of producing additional revenue," she says. "I think the discussion last week framed what is really a tug of war between Americans who have a challenge saving for retirement -- many are not on track to have enough money to replace the 80% of their income we would target -- and at the very same time that the tax-deferred status of these savings arrangements is certainly a target for current revenue."

Nordquist makes the case that "from a public opinion standpoint, we have to do a better job of getting policymakers, as well as Americans, to understand that these are not tax exemptions, it is a tax deferral."

"You can look at changing these programs as we collect more revenue now, but it is not like we are never going to collect it," she says. "Oftentimes, it gets filed in with the mortgage deduction and some of the other, true tax deductions. But this is really a tax deferral. I think retirement plans have to be part of the overall equation, and I don't think any of us in the industry are saying to just leave us alone completely. But let's be thoughtful and really think about the long-term ramifications of some of the things that are being proposed."

Nordquist worries that the current debates and proposals have been under the radar for the majority of Americans.

"Social security gets the headline because it has been out there for a while and it is a big fiscal challenge that impacts everybody," she says. "This has been much more of an undercurrent. I think the good news with the hearing last week is that it is starting to get a little bit more attention. How do we get more Americans to realize the fact that this could be on the chopping block and there could be some fairly dramatic changes that would impact all Americans and their ability to save for retirement?"

"Some of the proposals are more drastic than others," Nordquist adds. "I think

the Gale proposal would cause plan sponsors -- the corporations that sponsor these plans -- to really re-think whether they should put a match in. If the government is going to put in this 18% or 30%, they may think they can get rid of their match. They might say, 'I've got enough challenges in the health care arena right now.' To think that these types of changes would be put in place and there would not be kind of rethinking terms of how employers spend money on those plans is very naive on the part of those that propose them."

-- Written by Joe Mont in Boston.

>To contact the writer of this article, click here:

Joe Mont

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