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Letter From The US: 401(k) in the crosshairs of reform

Americans hold $5trn (€4.3trn) in 401(k) plans, amounting to 19% of all retirement assets. Since their launch in 1981, 401(k) plans have become the preferred employer-sponsored defined contribution (DC) retirement plan. But it is at risk of being reformed, as Congress launches the tax overhaul promised by President Donald Trump. 

Before implementing any changes, Congress should read ‘Ten Important Facts About 401(k) Plans’. It was published by the Investment Company Institute (ICI), an association representing US mutual funds, exchange-traded funds (ETFs), closed-end funds and unit investment trusts (UITs).

One fact is that 80% of households with DC plans agree that the “tax treatment of my retirement plan is a big incentive to contribute”. Contributions to 401(k)s come from pre-tax earnings, with withdrawals in retirement taxed as income.

The White House announcement in September of its tax reform, says little: “Tax reform will aim to maintain or raise retirement plan participation of workers and the resources available for retirement.” 

In fact, Republicans aim to pass a tax bill by reconciliation, rather than negotiation. This requires the bill to be deficit neutral.

Many experts have expressed their opposition to taxing 401(k) plans upfront. They are concerned that if workers cannot contribute pre-tax to their 401(k), they will save less. The alternative would be salary cuts.

The White House hopes to launch the tax reform programme by the year end but it will be controversial. 

In the meantime, here are some other facts about 401(k) plans. 

Some 51% of households that own DC accounts are not classified as rich. They have incomes of between $25,000 and $99,999 (as of mid-2016). More than one-third are younger than 40. 

Target-date funds (TDFs) are the second most popular investment option that 401(k)s offer, with nine funds offered on average. Equity funds are still the most common investment option, with 401(k) plans offering about 13 funds on average, of which 10 are domestic and three international.

Members of 401(k) plans pay lower fees than the average fund investor. In 2016, the average expense ratio for equity mutual funds offered in the US was 1.28%. But 401(k) plan participants who invested in equity mutual funds paid only 0.48%. And equity securities – equity funds, the equity portion of balanced funds, and company stock – represented most of 401(k) plan participants’ assets at 66.4% as of year-end 2014.  

Finally, employers make contributions in 77% of 401(k) plans; and fewer than one in five participants has outstanding loans.

If 401(k)s are taxed upfront they will become like the current Roth accounts with taxed contributions and tax-free withdrawals. Such a system could benefit younger workers if their pay increases during their career and they end up with more income when retired. On the other hand, the government will get more money now, but will lose later, that is why hawks consider ‘Rothification’ a gimmick. 

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