Three Reasons Why Limiting Pre-Tax 401K Deductions is Not a Good Idea

While it still remains to be seen what actual changes will take place under the final tax reform package, one idea that has received a lot of attention is the potential for new limits on 401K deductions. The Rothification of 401Ks, another way to describe the possible changes, has brought up a great deal of concern for middle income wage earners. With the current limit set at $18,000 ($24,000 for those over 50), the possibility of reducing those limits to a mere $2,400 (a number that has at least been whispered about) has brought fear to the investment world and great bit of frustration to those who are currently maxing out their retirement plans. In full disclosure, I am one of those who maxes out currently. However, whether I did or did not (and I certainly was not always in the position to max out my 401K contributions), I still would believe that any reduction would have a long term detrimental effect on both retirement savings and future government tax revenue. These are my three reasons why limiting pre-tax 401K deductions is not a good idea.

1.  The majority of those who currently set aside money in 401K plans will reduce the amount of their retirement savings contributions. Since I presently max out my contributions to the fullest extent of the current IRS limits, I contribute over and above the matching level of my employer.  If the IRS limits were reduced, while I may still contribute enough to get the employer match, I would certainly do no more. Other contributors may not even be able to contribute the matching amount as they may need that extra current income to pay the tax bill. Bottom line -- retirement savings contributions will take a hit. Is this really a good idea when so many Americans are woefully behind in preparing for their financial futures?
2. Unless taxation laws are adjusted again in the future, the future tax revenue of the US treasury will be drastically reduced. Think of the saying "robbing Peter to pay Paul," Or in this case, "robbing the future to pay for the present." Essentially, the government would trade future income for present income. With less money set aside for retirement fund contributions by millions of Americans, there will be a reduced amount returning in the future. In addition, given the Rothification of 401Ks, the future withdrawals would be tax free anyway. This creates a very real possibility that the future US government would have to go back on its word and tax future withdrawals out of necessity. I can see it now -- "austerity measures."
3. The value of the stock market will take a hit - twice. First of all, the stock market will be affected in the present due to less money flowing into mutual funds. With less money flowing into mutual funds there will be less investment in the market overall. At least 75% of my activity in the market occurs within my retirement funds, some of which is in individual stocks, and, with less money contributed to my retirement plans, the less stock I will be able to buy within those plans. In addition. the value of the market will be affected in the future when retirees begin to pull their money out of the market on a tax free basis (due to the Rothification of 401Ks). Without the worry of taxation, there will be little incentive to delay the withdrawal of money from retirement accounts once the magic retirement age has been achieved.

Therefore, reducing the limits of 401K deductions would be a very bad idea. I hope that this post is soon to be made moot, but it all remains to be seen. In fact, I heard as recently as today, a one-percenter suggest that reducing the limits would have little affect on contributions since most Americans do not max out their contributions anyway. That may be true, but reducing tax incentives for contributions, we will have many more future retirees solely dependent upon Social Security. And, Social Security? That is a whole other subject.