It’s a good idea to increase your 401(k) and IRA contributions to the absolute maximum while you still can.
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That means the full amount is $30,000 this year, or even more if you’re 50 or older. In 2024, the maximum 401(k) is $23,000 and the maximum IRA is $7,000, with additional contributions available for savers age 50 and older. It may also mean converting a traditional pre-tax IRA to an after-tax Roth IRA to maximize the after-tax amount of shelter.
reason? There’s talk in policy circles about eliminating these programs altogether, or at least eliminating the tax breaks, which is pretty much the same thing. That would be a political shock and an economic earthquake, especially for the middle class.
Policy enthusiasts argue that these accounts primarily benefit very high earners and do little to increase savings. They want to use these additional taxes to bail out Social Security, which is hurtling towards crisis.
Alison Schrager of the Manhattan Institute just wrote about this idea. The Center for Retirement Research at Boston University wrote an article about this last month. Michael Dolan, a law professor at the University of Virginia, helped defuse the situation several years ago by calling this middle-class tax avoidance a “fraud” that primarily benefits the wealthy.
At this point, no one is talking about anything retroactive. You won’t start paying taxes on funds already contributed to these accounts. Rather, the idea would be to eliminate tax credits in the future and replace them with a different system that does not have the same credits.
How serious is this? No one knows. It’s just a story at this point. But Social Security is in crisis. Ultimately, it will either cut benefits or raise taxes.
The argument against 401(k) plans and IRAs is that they are regressive. These benefit high income earners the most. That’s not entirely wrong. It is clear that if someone pays a higher tax rate, they will benefit more from tax credits. If he contributes up to $23,000 to a 401(k) plan and is in the top 37% of federal tax payers, his tax bill this year will be reduced by $8,500. If his federal taxes are in the 15% range, he will save less than $3,500.
However, there are multiple problems with this argument.
As MarketWatch’s Robert Powell pointed out when the idea first surfaced a while ago, these accounts don’t allow people to avoid taxes entirely. They just postpone. So reports about the regressivity of tax cuts may be overstated.
And yes, tax shelters help the wealthy, but they also help the middle class, who actually need the taxes. These plans can make a big difference for families trying to make ends meet while saving for retirement and, for example, a child’s college education. It’s very 1917 to torpedo a lifeboat used by the middle class because it might have rich people on board.
High-income earners, on the other hand, receive a larger tax deduction for their contributions. The reason is…well, they pay more taxes to begin with. Of course, but worth repeating.
It’s also not entirely clear how regressive these tax shelters actually are. If you work your whole life at an average-income job, save aggressively, and benefit from luck and a bull market, you might retire with a huge 401(k) balance. lucky you. However, you may end up paying a higher tax rate on withdrawals than you did on contributions, meaning it may not be as advantageous.
That’s an observation, not a complaint. That’s how the system is supposed to work. It’s progressive. On the other hand, if your retirement funds are very small, you will pay very little tax on withdrawals.
These tax shelters also have a number of important practical benefits for savers. These help people invest in stocks for growth as well as bonds for safety. Bond income and interest income are typically taxed at much higher rates than equity income. Tax shelters allow people to freely change and rebalance their portfolios without incurring additional taxes. By the way, this is not for nothing, but every year they free people from completely insane, stupid, and mostly pointless IRS paperwork.
These tax shelters also make simple and intuitive sense. I pay taxes on my income, but it’s money I can spend right away. Your retirement savings won’t be available for decades. You only pay taxes when you withdraw money from your account to use it.
According to calculations by Boston University, exiting tax-deferred 401(k) plans and IRAs would result in $185 billion in additional taxes annually.
Is there anything else that could raise nearly the same amount? A tiny, tiny tax on the assets of the super-wealthy.
The richest 0.1% currently own 12.4% of all wealth in America, according to Federal Reserve figures. In the late 1980s, during the era of Ronald Reagan and George H.W. Bush, this group owned 7.6% of the wealth.
Their total assets currently amount to $20 trillion. A 1% tax could raise $200 billion without affecting the retirement savings options of the middle class.
Fortunately, many of these wealthy people pay little or even no taxes. They may not even show up on the IRS’s “high income earners” list. You may remember 10 years ago when someone in this group ran for president and released his tax returns. It turns out Mitt Romney was paying 14% interest instead of 50% or 37%. And many of the really, really, really wealthy people pay even less, or nothing at all.
Historically, the average return on equity has been approximately 10% in nominal terms. So 1% tax is bupkis.
However, such a tax is unlikely to occur. That would upset the donor base. They might come get you and me instead. As analysts pointed out a decade ago, the wealthy get what they want from Washington time and time again. And while people may criticize the American system all they want, it’s still the best money can buy.