Most of us save for retirement because we want to enjoy our golden years without putting a burden on our kids. A lower tax bill isn't our chief motivation, but it sure doesn't hurt.
See Also: Retiree Tax Map
Now, diligent savers face the possibility that they'll lose tax breaks designed to encourage virtuous behavior. President Obama's 2014 budget proposes capping tax-preferred retirement plans—including individual retirement accounts and 401(k) plans—at $3.4 million per person. It isn't the first time tax-preferred retirement savings plans have been targeted. President Obama's deficit-reduction commission suggested limiting annual contributions to tax-preferred accounts to $20,000, or 20% of income, whichever is lower.
Retirement savings plans offer a potentially rich source of tax revenue. The Joint Committee on Taxation estimates that excluding contributions and earnings from taxes will cost $515 billion for the five-year period ending in 2014. Only the exclusion for employer-provided health insurance costs more.
Supporters of limits on tax-preferred retirement plans argue that they would primarily affect affluent taxpayers. Two-thirds of U.S. households have saved less than $50,000 for retirement, reports the Employee Benefit Research Institute. Critics counter that taxes on 401(k) plans and traditional IRAs are merely deferred, and that the money will be taxed when it's withdrawn. They also argue that proposals to limit tax-preferred savings would indirectly affect middle-income savers, too.
President Obama's $3.4-million cap is based on the amount of money a retiree would need to buy an annuity that produces $205,000 a year. But record-low interest rates have increased the cost of buying an annuity, artificially inflating the size of that lump sum; even a modest increase in interest rates could lower the savings cap to $2.2 million, according to EBRI.
Workers whose savings are nowhere near the cap could be affected if the change causes small-business owners to scrap retirement savings plans for their employees, says Jack VanDerhei, research director for EBRI. Small-business owners may contribute up to $56,500 to a tax-deferred account in 2013, but federal rules require them to make their plan available to employees. If contributions are capped, business owners may decide to terminate their 401(k) plans in favor of tax-efficient investments available to high-income investors, VanDerhei says.
These proposals are a long way from becoming law. In the meantime, don't use them as an excuse to stop saving. If anything, says Michael Kitces, a certified financial planner in Columbia, Md., you should save more. He notes that you would be prevented from making contributions once you hit the threshold, but there would be no limit on tax-preferred investment growth. To get the most out of your tax-deferred investments, he says, "you want to hit the cap as soon as you can."