Now that 401(k)s have become the primary source of retirement savings for the middle class working in the private sector, we should restore the large tax incentive and bring fees into line with taxable investment standards. One easy change is to allow workers to roll 401(k) funds over to self-directed IRAs at any time (now they can do it only when they leave a job). 2  That would force 401(k) platforms to compete in an open market, and it costs nothing.

Reducing taxes on 401(k)s will cost the government money, but it could be a good investment if it results in retirement security for more middle-income households. Two simple ideas are to make new 401(k) contributions and accumulated returns from them tax-free when withdrawn in retirement by below-median-income households, and to exclude FICA payroll deductions as well as income tax from 401(k) contributions. Not only would these make the tax advantages of 401(k)s compelling again, they eliminate the danger many workers fear that marginal income tax rates will be higher when they retire (a more reasonable fear at a 12% marginal rate with 2020 government deficits than it was in 1980 with a 43% marginal rate and far smaller deficits). And all the benefit of these changes go to below-median households in retirement, there’s no subsidy for households in the top half of the income distribution.

The claim that a frog placed in slowly warming water will die without trying to escape is factually incorrect, but too useful a metaphor to discard. We have been slowly raising the temperatures on 401(k)s for 40 years, and we’re nearing the point that they no longer make sense for workers, except those fortunate enough to be offered the best plans or good employer matches. I don’t know which is worse, if the worker frog jumps out and thereby exacerbates the middle-class retirement savings problem, or if the worker frog stays in and finds its retirement plan eroded by unexpected effects of fees and taxes. So let’s turn off the heat and add some cold water.

  1. Median-income, four-member households in retirement paid 0% capital gains taxes in 2018, the last year for which data are available. Higher-income households and those in different tax situations may pay at rates of 15% or 20% on long-term capital gains.
     
  2. Individual employers may allow rollovers while employees continue to work, but they are not required to. Those that do allow it often have minimum age requirements. Moreover it’s usually the employers with the best plans that allow employees to opt out.

This article was provided by Bloomberg News.

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