The Disappearing 401k Plan

On September 2, 1974, President Ford signed into law the Employee Retirement Income Security Act of 1974 (ERISA). This was the beginning of establishing additional rights for employees as participants in company retirement plans. Prior to this, employees had very little knowledge of how their retirement account was managed, with no ability to make changes. However, in 1977, an amendment to ERISA established for the first time in history the ability for people to contribute into their own retirement account; it was titled the “Individual Retirement Account”, today known as the IRA.

Contributions into the newly established IRA account were not tax-deductible accounts, and the maximum annual contribution was only $1500. Up to 1974, the only retirement accounts available to employees were employer or union-controlled pension plans. Employees were not involved or aware of how the employer’s contributions were being invested and typically received an annual statement indicating very limited information about the portfolio other than their projected future retirement income benefit. Other than employer-sponsored retirement plans, individuals had no other means to contribute into a retirement account pre-tax and with account earnings tax-deferred to retirement (current law allows keeping funds tax-deferred in any retirement plan to age 73).

Years earlier, US Representative Eugene Keogh sponsored the creation of KEOGH retirement plans for those who owned their business, which was signed into law in the Self-Employed Individuals Tax Retirement Act of 1964.

Following the creation of the IRA, a plethora of acronym retirement accounts followed in subsequent revisions, including Simple Employer Plan IRA (SEP), Savings Incentive Match Plan for Employees IRA (SIMPLE), and Salary Reduction Simplified Employee Pension Plan (SARSEP). Congress is as notorious for creating acronym terms as the aviation industry!

Nonetheless, the passage of ERISA was the beginning of new types of retirement savings accounts never available before. The most significant advancement for individuals to save for retirement was established on November 6, 1978. On this date, Congress enacted IRS Code Section 401(k) as part of the Revenue Act, creating the Profit Sharing 401(k) Retirement Plan. Small and large companies began exchanging their former pension plans funded entirely by the employer for the new Profit Sharing 401(k) retirement plan that can be entirely funded by employee payroll deductions.

For the first time in history, employees not only had the ability to make tax-deductible contributions into their own retirement accounts but also had investment discretion over their accounts. The 401(k) has been a huge success and has become, for many, their largest asset at retirement, even greater than their own home. Assets in 401(k)’s have exploded in value with employee and employer contributions along with account appreciation. Statista estimated that 61% of all employees have access to an employer-sponsored 401(k) plan, and Investment Company Institute estimated total assets in 401(k)’s as of June 2021 have ballooned to over $7.3 Trillion or about 27.5% of the US GDP.

The most valuable aspect of the 401(k) is the availability for all wage earners to save some amount by payroll deduction. In 2023, the maximum annual employee contribution is $22,500, up from $20,500 in 2022. President George W Bush supercharged the 401(k) by signing the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA – another great acronym) and creating the “Catch-Up” contribution. This was an extensive new tax law that changed annual contribution limits on retirement accounts and lowered income tax brackets. The Catch-Up provision allowed exclusively those over age 50 to contribute an additional amount into their 401(k) with all the same 401(k) benefits and tax deductions. In 2023, the Catch-Up provision adds an additional $7,500 allowing those over age 50 to contribute a total of $30,000 either in the tax-deferred or ROTH (if offered).

This is serious savings for most people that in just ten years, contributing the annual maximum amount can increase to over $432,000 based on a 7% annualized return.

All sounds too good to be true. Right? Well, last year, Congress decided this free ride of tax-deferred savings has gone on too long. President Biden signed on December 29, 2022, the Setting Every Community Up for Retirement Enhancement 2.0 (SECURE 2.0 – what a terrific acronym!). SECURE 2.0 adds many enhancements to retirement plans, including extending the age one is required to make distributions, increasing annual contributions, and an annual increase of maximum contributions. The Catch-Up allowance for 401(k) plans was increased to $10,000 for workers 60 to 63 beginning in 2025.

The catch (no pun intended)? All Catch-Up contributions beginning in 2024 for those earning more than $145,000 must be deposited into the ROTH account. Under current law, contributions into ROTH accounts are taxable, and all future distributions are tax-free. In other words, pay your taxes now, and the IRS will let you take your future distributions tax-free.

The risk is Congress changes the rules in the future, making all ROTH distributions taxable AGAIN and especially for those in higher income brackets. Double taxation will, for most people, wipe out all cumulative returns, especially if your income during retirement doesn’t change much from your working years. Simple line-item legislation changes, as they did in December, could suddenly make all your ROTH account taxable again.

WHAT DOES THIS MEAN TO ME?

While Congress has improved in many ways the ability to save for retirement, it is important to monitor tax laws as it concerns your retirement account. The 401(k) retirement plan is not disappearing, but the potential of double taxation or worse retirement distributions can impact your overall returns. Congress has been eyeing for years the $7.3 Trillion untaxed funds in retirement plans and changes in tax law for distributions, maybe more when than if.

The SECURE 2.0 increased annual contributions to retirement plans and extended the date you are required to take distributions to age 73. However, they also added some new twists you need to pay attention to. If your income is over $145,000, you may reconsider depositing your Catch-Up contributions into the ROTH 401(k) account in 2024.

The key benefit of ROTH accounts is the investment gains are tax-free. The second benefit is the ability to buy and sell the investments in your ROTH account without incurring a taxable event. Conversely, since the contributions are taxable, the ultimate savings is the avoidance of long-term capital gain tax when you sell or take a distribution. Maybe a small difference in cost depending on investment performance. However, if Congress suddenly makes your entire ROTH account taxable again, all benefits are gone, and you would have been better off taking the amount considered for Catch-Up and investing in your individual or trust account. In your individual account, you don’t have to worry about double taxation, and you can hold onto your investments as long as you want.

Let us know if you have any questions about this Weekly Brief or about your own retirement planning. We welcome the opportunity to be of service to you and your family.