Republican lawmakers are under pressure to put out new tax reform legislation by year’s end, but to make that happen, they need ways to pay for the hefty tax cuts proposed so far.
A proposal from President Trump calls for tax cuts for taxpayers at every income level, a reduction in the corporate income tax to 20 percent from 35 percent, and the end of the estate and alternative minimum taxes, among other things.
So far, implemented as is, the plan would add $1.5 trillion to the federal deficit, according to the Tax Policy Center. The deficit is the amount by which total government spending exceeds tax revenues for the fiscal year.
Such calculations have Republicans scrambling to figure out a way to achieve tax reform without adding to the deficit.
This week, Republicans lawmakers were rumored to be considering offsetting the cost of their tax cuts by reducing the 401(k) contribution limit for workers. (Trump swiftly denounced that plan on Twitter.)
At the moment, workers under 50 are able to contribute up to $18,000 in pre-tax dollars each year to a 401(k) retirement account. The amount is tax-deductible and reduces the overall amount the worker pays in annual federal income tax. The tax-deductible contribution limits are set to rise to $18,500 and $24,500, respectively, in 2018.
The Wall Street Journal reports Republican house leaders were considering a plan that would cut annual tax-deductible contribution limits on 401(k)s and, possibly, IRAs, down to just $2,400.
Workers would need to place any amount they’d like to save above that limit in a Roth IRA, which would be a boon to the federal government. Contributions made to Roth accounts are taxed immediately, not when the benefit is drawn out as with 401(k)s, so it would be one way to drive up tax revenue in the face of tax cuts.
On Oct. 23, Trump tweeted, “There will be NO change to your 401(k).”
There will be NO change to your 401(k). This has always been a great and popular middle class tax break that works, and it stays!
— Donald J. Trump (@realDonaldTrump) October 23, 2017
Started by the IRS in 1978, retirement savings plans like the 401(k) and Individual Retirement Account (IRA) have been financial staples among middle-class families. And as pension plans have been phased out over time, defined contribution plans like the 401(k) plan have taken their place as a principal retirement vehicle for those families.
The proposed limit could prove costly to many Americans, as they are likely contributing above $2,400 annually to a 401(k) retirement account. According to Fidelity Investments, the average 12-month savings rate for 401(k) accounts in 2016 reached a record high of $10,200.
The notion of cutting back the amount workers can contribute, tax-free, to retirement accounts is understandably unsettling to many workers and members of the asset management community. That’s in part because, as Trump has noted on Twitter, 401(k) contributions allow many middle-class Americans a tax break.
Here’s how it works. For this example, we based our estimates on 2016 income tax brackets.
Let’s say Robin is head of her household and drew a base salary of about $55,000 in 2016, placing her in the 25% tax bracket. She deferred 15% of her pre-tax income, or $8,250, to her 401(k) retirement account. Her $8,250 contribution reduces her annual taxable income to $46,750.
That newly calculated income not only dropped Robin to the 15% tax bracket, but she also saved nearly $1,700 in federal income taxes.
The administration’s tax plan reduces the seven existing tax brackets to just three — 12, 25 and 35 percent (with a possible fourth tax bracket for the highest-earning individuals). But the plan did not specify income ranges. As of this writing, it is unclear which incomes would fall into which bracket.
For the purposes of this example, let’s assume that Robin’s income would still land her in the 25 percent income tax bracket.
With a 401(k) contribution limit reduced to $2,400, she would have been taxed on $52,600 at a 25 percent tax rate. That would have increased the amount she paid in federal income tax to $7,297.50 from $6,350 in 2016.
It’s unclear if the new tax bill will actually include a reduction in 401(k) contribution limits. But one thing that is clear is this: If the tax-reform measures are to pass, funding for more than $1.5 trillion in lost revenue to tax cuts over the next decade has to come from somewhere.
The plan proposes to reduce the tax burden on middle-class Americans by doubling the standard deduction Americans can make when filing their federal income taxes to $12,000 for individuals and $24,000 for married couples filing jointly. However, it would eliminate the option to itemize deductions instead of using the standard deduction. The proposed plan would also increase the child tax credit — currently $1,000 — by an unspecified amount and create a $500 tax credit for nonchild dependents, like elderly family members. These and other tax cuts may translate to big losses in federal tax revenue.
An independent analysis by the Tax Policy Center, a nonpartisan think tank, claims the new tax plan would reduce federal revenues by $6.2 trillion over the first decade, while federal debt could rise by at least $7 trillion in the same period.