The Impact of a Retirement Savings Account Cap

[SumDay]

Released yesterday: PLANSPONSOR.com - ERIC Urges Caution on Tax Treatment of Retirement Plans

In a letter submitted to the House Ways and Means Committee’s Tax Reform Working Group on Pensions and Retirement, Kathryn Ricard, ERIC’s Senior Vice President for Retirement Policy, wrote: “Changing the current tax treatment of employer-sponsored plans would jeopardize the retirement security of tens of millions of workers, impact the role of retirement assets in the capital markets, and create challenges for future generations of retirees in maintaining their quality of life.”

 

[growing_older]

From that same source:

President Obama’s proposal to limit the amount American workers could save for retirement would adversely impact overall retirement savings, as changes to the rules and regulations associated with saving for retirement often have unintended consequences, including a “chilling effect” on savings even by individuals who are unaffected by the rule changes.

 

[bUU]

Sounds like FUD to me. The letter didn't impress me as being particularly based on any real data providing evidence for any of its claims. It makes a lot of loose implications, but doesn't tie any of them back to any evidence specifically related to the specific group of individuals affected (i.e., those who will achieve >$3M in retirement savings). As a matter of fact, the only really defensible point that I could see coming out of the letter (based on the fact that the situation is tenuous because of the voluntary nature of offering 401k plans) is a new law standardizing and requiring 401k plans for all... a retirement ACA.

 

[sheehs1]

SumDay and growing older, thanks for the update on some of the conversation that is being generated with this proposal. My sentiments exactly. More from the standpoint of having our government mandate "how much is enough" for anyone.
I'm still o.k. in limiting annual contribution amounts and generating more current tax revenue that way, if need be, but having our government implement a max cap on it is disturbing to me. Plus, I don't feel it is necessary. The government WILL get the tax associated with any deferred amounts at some point.

 

[Independent]

I don't think we know.
This says nothing about whether the additional gains (over the "maximum permitted accumulation") will be taxed or not.

"Accrued interest" is a common term, but that use of "accrue" doesn't fit with the clause that follows it in the above quote.

The proposal is so sloppily worded as to, apparently, be a blank slate upon which people can project whatever meaning they prefer. We've seen that technique before . . .it doesn't lead to good outcomes.

The wording in the proposal isn't the language in a law, but I think it's pretty clear that they aren't planning to tax the investment earnings inside IRAs, 401(k)s, etc. The proposal says no new contributions.

The proposal combines DB and DC plans. The limit is actually the combined effect of both. The Treasury puts out some annuity factor, I multiply my DC account balances by that factor to get a monthly income, add that to my DB monthly income (the amount already earned), and compare to the current DB cap, which is the $205k. If I'm over, I can't contribute additional amounts to my DC accounts, and my employer can't grow my DB benefit.

I think the word "accrual" is used to refer to DB benefits. If my DB benefit at the beginning of the year is an annuity of $100k/year, and the benefit at the end of the year is $110/year, then I've "accrued" $10k of new benefits in this year.

For example, this description of current law (my bold)

the limitations on accruals under defined benefit plans and the limitations on contributions under defined contribution plans are not applied by aggregating all such arrangements.

or this from the proposed rule:

Plan sponsors of defined benefit plans would report the amount of the accrued benefit and the accrual for the year, payable in the same form.

 

[Independent]

Released yesterday: In a letter submitted to the House Ways and Means Committee’s Tax Reform Working Group on Pensions and Retirement, Kathryn Ricard, ERIC’s Senior Vice President for Retirement Policy, wrote: “Changing the current tax treatment of employer-sponsored plans would jeopardize the retirement security of tens of millions of workers, impact the role of retirement assets in the capital markets, and create challenges for future generations of retirees in maintaining their quality of life.”

I'd like to see the facts to support the "tens of millions of workers".

This proposal impacts people who are using tax-favored programs to get annual retirement benefits of $205k (not inflation adjusted) or more. What percent of the working population would that be? I'm guessing less than 1%. (What percent of workers earn more than $200k? What replacement ratio are they targeting?)

Since there are about 150 million workers, and "tens of millions" means at least 20 million, they are claiming an impact on at least 20/150 = 13% of all workers. Doesn't pass my smell test.

 

[meierlde]

The wording in the proposal isn't the language in a law, but I think it's pretty clear that they aren't planning to tax the investment earnings inside IRAs, 401(k)s, etc. The proposal says no new contributions.

The proposal combines DB and DC plans. The limit is actually the combined effect of both. The Treasury puts out some annuity factor, I multiply my DC account balances by that factor to get a monthly income, add that to my DB monthly income (the amount already earned), and compare to the current DB cap, which is the $205k. If I'm over, I can't contribute additional amounts to my DC accounts, and my employer can't grow my DB benefit.

I think the word "accrual" is used to refer to DB benefits. If my DB benefit at the beginning of the year is an annuity of $100k/year, and the benefit at the end of the year is $110/year, then I've "accrued" $10k of new benefits in this year.

For example, this description of current law (my bold)



or this from the proposed rule:

If this is the case, then the goal is to extend to DC plans what also applies to DB plans. If you read proxy statements you will find that there are plans to make up the pension for execs above the ERISA pension Limit, which is currently $205k per year for 2013. So I suspect that the proposal is a reaction to the change to DC plans and brings them under the cap. Also it brings the cash value DB plan under the limit as well. Currently with a DB pension the benefit is limited, and companies if you read the comp section of the proxy provide a make up plan for execs to handle the overage (a supplemental pension plan or the like, that is just an unsecured debt of the corp.).
So the idea here was to have the tax code catch up to the changes in the benefit landscape, although it sure was communicated badly.

 

[samclem]

The wording in the proposal isn't the language in a law, but I think it's pretty clear that they aren't planning to tax the investment earnings inside IRAs, 401(k)s, etc.

Thanks. We're all groping about here because the language isn't very precise. If you are right then it seems to mean that gains (accruals) in DB plans count, effectively, as contributions (since they'd have to be removed or a tax paid if they exceeded the allowable level) but that gains in DC plans (which any normal person would also call an "accrual") would not. That would be interesting--gains in DC plans would grow unrestricted and untaxed (until withdrawn), but gains in DB plans (over the amount deemed "sufficient" by the government) would not. And since everything is treated in aggregate, the growing DC balance effectively removes the tax advantages on the DB plan (which must be continually reduced to stay under the "allowable" amount).

Those who believe this proposal is intended to put a stop to what Mitt Romney did with his investments will likely be disappointed if your interpretation is correct, because many object to the untaxed >growth< of IRA investments, which would not be addressed if you've got it right.

 

[clifp]

I'd like to see the facts to support the "tens of millions of workers".

This proposal impacts people who are using tax-favored programs to get annual retirement benefits of $205k (not inflation adjusted) or more. What percent of the working population would that be? I'm guessing less than 1%. (What percent of workers earn more than $200k? What replacement ratio are they targeting?)

Since there are about 150 million workers, and "tens of millions" means at least 20 million, they are claiming an impact on at least 20/150 = 13% of all workers. Doesn't pass my smell test.

It probably won't actually impact tens of million but it could easily impact the planning for tens of millions.

Imagine you are doing well and hit $400K by the time you are 40. (A number I hit well before I was 40.) Now 10% returns will have you hit the cap well before you are 65. So a very reasonable approach would be to decrease your contribution to do what is necessary to get the company match.

Of course lots of events could happen to prevent you from ever getting anywhere close to $3 million (job loss, bad investment returns etc.) but most people don't forecast bad stuff happening. While many people on this forum are disciplined enough to cut their 401 contribution from 12% to 5% (company match level) and save the remain 7% in Vanguard index funds, most people are not.

They could easily find themselves out of a job in 20 years with a lot less money then if they had just maxed out their 401K.

 

[Independent]

Thanks. We're all groping about here because the language isn't very precise. If you are right then it seems to mean that

1) gains (accruals) in DB plans count, effectively, as contributions (since they'd have to be removed or a tax paid if they exceeded the allowable level) but that gains in DC plans (which any normal person would also call an "accrual") would not.

2) That would be interesting--gains in DC plans would grow unrestricted and untaxed (until withdrawn), but gains in DB plans (over the amount deemed "sufficient" by the government) would not.

3) And since everything is treated in aggregate, the growing DC balance effectively removes the tax advantages on the DB plan (which must be continually reduced to stay under the "allowable" amount).

4) Those who believe this proposal is intended to put a stop to what Mitt Romney did with his investments will likely be disappointed if your interpretation is correct, because many object to the untaxed >growth< of IRA investments, which would not be addressed if you've got it right.

Lots of stuff here:

1) For DB plans, the sponsor holds assets that are (hopefully) growing with investment returns. Those assets are less than the dollars which are promised to the employee. Each year the plan is supposed to earn, untaxed, investment income that is intended to grow the current assets just enough to eventually pay the benefits. I'd call that investment income "gains". But I think they are using "accruals" to mean new promises of additional benefits according the the benefit formula. Using those words, the "gains" in DB and DC plans are treated the same, they both are earned and not taxed in the year they are earned.

2) As in (1), some investment gains in DB plans are needed just to fund benefits that were earned in the past. No changes there, that's just like DC.
I assume there are current rules for DB plans that have such great investment performance that they are substantially over-funded. I don't know exactly what those rules are - though I think the first thing the employer can do is to stop making new contributions to the over-funded plan. I think they can also use the excess funding to unilaterally increase benefits. And, probably, there is some way to extract it (they may have to close the plan to do that, I'm really stretching here). Under current law, if they use the excess returns to increase existing benefits, they cannot do an increase for someone who has already hit the cap. This proposal doesn't seem to change that.

3) Yes, because everything would be aggregated, a worker could find that his growing DC balance forces him to tell his employer that he cannot accrue any new DB benefits. But, no, I don't see anything that says the employer would have to reduce DB benefits already earned.

4) I agree. Suppose Romney only had one IRA, and he put something in it that somehow met the funding limit, then exploded in value. This does not force him to take any money out of that IRA. It does prevent him from making any new contributions to any IRA or other tax-favored retirement plan. He can't play that card twice.

 

[Independent]

It probably won't actually impact tens of million but it could easily impact the planning for tens of millions.

Imagine you are doing well and hit $400K by the time you are 40. (A number I hit well before I was 40.) Now 10% returns will have you hit the cap well before you are 65. So a very reasonable approach would be to decrease your contribution to do what is necessary to get the company match.

Of course lots of events could happen to prevent you from ever getting anywhere close to $3 million (job loss, bad investment returns etc.) but most people don't forecast bad stuff happening. While many people on this forum are disciplined enough to cut their 401 contribution from 12% to 5% (company match level) and save the remain 7% in Vanguard index funds, most people are not.

They could easily find themselves out of a job in 20 years with a lot less money then if they had just maxed out their 401K.

Based on anything I've read, I'd say that if you hit $400k well before you were 40, you are an extremely rare person. You are in the top 1% of successful savers. I'd also say that if you know how to get inflation + 10% over a 25 year period, you are in the top tier of investors.

The people who are likely to get balances that get them across the line are highly compensated workers. Employers already set up special, non-tax-favored retirement plans for them. (If we had a benefits consultant here, he'd explain to us what companies already do for employees who hit the current DB plan $205k cap.) If this proposal really became law, I expect we'd see employers setting up taxable 401k clones so the highly compensated can still get their match.

 

[clifp]

Based on anything I've read, I'd say that if you hit $400k well before you were 40, you are an extremely rare person. You are in the top 1% of successful savers. I'd also say that if you know how to get inflation + 10% over a 25 year period, you are in the top tier of investors.

The people who are likely to get balances that get them across the line are highly compensated workers. Employers already set up special, non-tax-favored retirement plans for them. (If we had a benefits consultant here, he'd explain to us what companies already do for employees who hit the current DB plan $205k cap.) If this proposal really became law, I expect we'd see employers setting up taxable 401k clones so the highly compensated can still get their match.

I certainly don't know how to get inflation +10%. AFAIK the proposal isn't tied to inflation although that obviously could change, and I agree that I am an above average saver and investor (although there are plenty on this board that are better).

But I think you maybe forgetting what a great run stocks had in the 1980s and 1990.
For instance investing $2,000 a year in the NASDAQ composite (which could be replicated or even exceed with the Janus funds) from 1980 to 1990, and then never adding a dime gave you $350,000 in retirement saving by Jan 2000. I invested more than 2K a year starting in 1983, and my 401K and IRAs were tech focus although I started lighten up in the mid 1990s so I mostly missed the huge run up in my 401K. But still accumulated 400K around 37 or 38 wasn't that hard in bull market.

The point being if the cap existed in 1999 people who were investing from 1980 to 2000, might have looked their account balances in Dec 1999, and decided no need for me to contributed any more because of the cap. They'd wake up a decade later and found they still had $350,000 and that at age 50 age 350K wasn't a ton of money..

 

[Texas Proud]

Based on anything I've read, I'd say that if you hit $400k well before you were 40, you are an extremely rare person. You are in the top 1% of successful savers. I'd also say that if you know how to get inflation + 10% over a 25 year period, you are in the top tier of investors.

The people who are likely to get balances that get them across the line are highly compensated workers. Employers already set up special, non-tax-favored retirement plans for them. (If we had a benefits consultant here, he'd explain to us what companies already do for employees who hit the current DB plan $205k cap.) If this proposal really became law, I expect we'd see employers setting up taxable 401k clones so the highly compensated can still get their match.

They would not have to set up, as you put it, a taxable 401(k)... most large companies already have a non-qualified plan in place for high wage earners... when I was at mega, if you qualified for the plan you got to choose how much of your bonus went into the plan... you did not get to choose the investments, but the money was invested well....

As mentioned, this was considered a general obligation of the company, but I think they had set up a separate company that was BK safe.... IOW, it only held the funds of the executives and if anything went wrong with the main company it was 'safe'.... not sure if this is true...

 

[Independent]

I certainly don't know how to get inflation +10%. AFAIK the proposal isn't tied to inflation although that obviously could change, and I agree that I am an above average saver and investor (although there are plenty on this board that are better).

But I think you maybe forgetting what a great run stocks had in the 1980s and 1990.
For instance investing $2,000 a year in the NASDAQ composite (which could be replicated or even exceed with the Janus funds) from 1980 to 1990, and then never adding a dime gave you $350,000 in retirement saving by Jan 2000. I invested more than 2K a year starting in 1983, and my 401K and IRAs were tech focus although I started lighten up in the mid 1990s so I mostly missed the huge run up in my 401K. But still accumulated 400K around 37 or 38 wasn't that hard in bull market.

The point being if the cap existed in 1999 people who were investing from 1980 to 2000, might have looked their account balances in Dec 1999, and decided no need for me to contributed any more because of the cap. They'd wake up a decade later and found they still had $350,000 and that at age 50 age 350K wasn't a ton of money..

Sorry for the slow response, I had some technical problems.

Yes, this proposal is indexed for inflation. The cap is tied to the maximum DB plan benefit, which is currently $205k. That number has been indexed since EGTRRA was passed in 2001. There is nothing in the proposal about un-indexing it.

I don't understand "no need for me to contribute any more because of the cap". Do you mean "contribute more to my 401k plan"? or "contribute more to my retirement savings"?

There's nothing in the proposal that should change anybody's attitude toward saving for retirement. The only impact would be where they saved.

Suppose I'm a great, 40 year old investor who found that I had $400k in my 401k in 2000. Looking ahead, I can imagine that I will eventually hit the $3.4 million cap on qualified accounts. Further, I can imagine that after I hit that cap, I won't be getting my employer match on my 401k*.

Note that I'm only 12% of the way to the cap, I still have to build up the other 88%. Still, I am so concerned that I may eventually lose some future match, that I decide to put some of this year's retirement saving into an after-tax asset.

In 2001, I discover that my investing genius was just riding a bubble up. My balance drops to $300k. I decide I don't need to worry about building up "too much" qualified plan assets, and I go back to putting all my retirement savings into the 401k. IMO, that's a a very rare story, and it has minimal impact on my eventual financial situation.

I can't imagine anyone who is sharp enough to figure out the 401k match angle, who would simply stop saving money for a decade because he might, someday, be forced to save in non-qualified accounts.

* But, note TP's post above. There's a good chance my employer will find a way to get me the match in a non-qualified plan.

 

[meierlde]

* But, note TP's post above. There's a good chance my employer will find a way to get me the match in a non-qualified plan.

Note that in addition to the supplemental plan at my megacorp (retired) you could contribute after tax dollars as well (before roth 401ks were allowed). Again due to lack of details would roths be affected. If roths were still allowed (meaning the deferral of taxes on gains) then you would just switch the place the funds went. I do expect the roths to eventually get RMD's so that they can not become perpetuities as they are now, perhaps on anyone that inherits one.

 

[Independent]

Note that in addition to the supplemental plan at my megacorp (retired) you could contribute after tax dollars as well (before roth 401ks were allowed). Again due to lack of details would roths be affected. If roths were still allowed (meaning the deferral of taxes on gains) then you would just switch the place the funds went. I do expect the roths to eventually get RMD's so that they can not become perpetuities as they are now, perhaps on anyone that inherits one.

My employer offered supplemental, non-qualified plans, too.

The intent of this proposal seems to be to wrap all types of qualified retirement savings into one bundle, and then put a cap on that bundle. I'd be surprised if Roth's weren't included in that bundle - i.e. you can't put additional funds into your Roth after you've hit the cap.

The language is very brief: "(i.e., IRAs, section 401(a) plans, section 403(b) plans, and funded section 457(b) arrangements ...)".
A Roth IRA is an IRA. I've been told that 401(a) is the umbrella language at the beginning of section 401 which covers everything else, including 401k and Roth 401k.

Under current law, a non-spouse who inherits a Roth has two distributions options - within 5 years or lifetime using the life expectancy factors. This proposal would eliminate the life expectancy factors option. (p. 163)
http://www.treasury.gov/resource-center/tax-policy/Documents/General-Explanations-FY2014.pdf

 

[clifp]

Sorry for the slow response, I had some technical problems.

Yes, this proposal is indexed for inflation. The cap is tied to the maximum DB plan benefit, which is currently $205k. That number has been indexed since EGTRRA was passed in 2001. There is nothing in the proposal about un-indexing it.

Well yes and no the DB benefit is indexed to inflation.
However the cap is based on an $205,000 payment. That payment not adjusted for inflation.

A taxpayer who has accumulated amounts within the tax-favored retirement system (i.e., IRAs,section 401(a) plans, section 403(b) plans, and funded section 457(b) arrangements maintainedby governmental entities) in excess of the amount necessary to provide the maximum annuity permitted for a
tax qualified defined benefit plan under current law (currently an annual benefitof $205,000 payable in the form of a joint and 100% survivor benefit commencing at age 62 and continuing each year for the life of the participant and, if later, the life of the participant’sspouse) would be prohibited from making additional contributions or receiving additionalaccruals under any of those arrangements. Currently,the maximum permitted accumulation for
an individual age 62 is approximately $3.4 million.

I should point out that best quote I could find for 205K annuity with a joint survivor option was 3.85 million. For a company I trust like Berkshire Hathaway the amount was over 4 million, and if I had a wife who was say ten year younger you actually need 4.5 million to get 205K. The 3.4 million only gets you $154,000 not a bad income but hardly rich especially if we have a period of high inflation when you retire on your fixed SPIA.

I don't understand "no need for me to contribute any more because of the cap". Do you mean "contribute more to my 401k plan"? or "contribute more to my retirement savings"?

There's nothing in the proposal that should change anybody's attitude toward saving for retirement. The only impact would be where they saved.

Suppose I'm a great, 40 year old investor who found that I had $400k in my 401k in 2000. Looking ahead, I can imagine that I will eventually hit the $3.4 million cap on qualified accounts. Further, I can imagine that after I hit that cap, I won't be getting my employer match on my 401k*.

Note that I'm only 12% of the way to the cap, I still have to build up the other 88%. Still, I am so concerned that I may eventually lose some future match, that I decide to put some of this year's retirement saving into an after-tax asset.

Well I think we will just agree to disagree on this. Even for a good saver LYBM person like myself, maxing out my 401K was by far the easiest way of saving. I never saw the money it just disappeared into my 401K balance and (almost) every quarter I see the numbers get bigger and plus I knew for every $1 I put in my 401K I saved $.40 on my taxes which lessened the pain of saving. Psychologically it is much easier to save that way than it is to write a check to Vanguard,Schwab, Fidelity, with after tax money to invest in a index fund.

There are host of problems with this proposal including that it doesn't actually raise much money just collects the taxes sooner. But the biggest one is sends exactly the wrong message, if you save too much for retirement you could get hosed.

If they want to fix "problem" of saving too much for retirement, then the other proposal. Requiring non-spousal beneficiary to withdrawal all of their IRA money over 5 year instead of the lifetime. Solves 90% of the problem with lot less paperwork and hassle.

 

[bUU]

That payment not adjusted for inflation.

If that's true (it's impossible to tell because the bill hasn't been written yet) then let's fix that.

I should point out that best quote I could find for 205K annuity with a joint survivor option was 3.85 million.

The proposal doesn't say anything about joint survivor option. Regardless, if the numbers are off a little, then let's fix that.

not a bad income but hardly rich

I think it is important to remember that tax deferral is granted by society because it supports a public interest, and "not a bad income" is actually beyond what is needed to serve the public interest; it actually includes some gravy, in that regard.

But the biggest one is sends exactly the wrong message, if you save too much for retirement you could get hosed.

The proposal doesn't send that message; the detractors do that.

 

[Independent]

Well yes and no the DB benefit is indexed to inflation.
However the cap is based on an $205,000 payment. That payment not adjusted for inflation.

I think you're saying that the maximum DB benefit will continue to be indexed to inflation, but the cap on DC accumulations won't. I don't see how that's possible. Read the next paragraph.

The math goes like this:
1) I add up all my DC balances,
2) multiply the total by an annuity factor provided by the IRS (apparently about 6% for a 62 year-old),
3) add all my DB benefits to the number I got in step 2
4) compare to this year's DB maximum benefit.

If step 4 says I'm over the max, I can't contribute this year to my DC qualified accounts, and I can't accrue additional DB benefits. Since the DB benefit max is indexed, the cap on DC accumulations is also indexed.

If you go down two paragraphs you'll find:

... when the maximum defined benefit level increases as a result of the cost-of-living adjustment, the maximum permitted accumulation will automatically increase as well.

That's the natural result of the math above.

Well I think we will just agree to disagree on this. Even for a good saver LYBM person like myself, maxing out my 401K was by far the easiest way of saving. I never saw the money it just disappeared into my 401K balance and (almost) every quarter I see the numbers get bigger and plus I knew for every $1 I put in my 401K I saved $.40 on my taxes which lessened the pain of saving. Psychologically it is much easier to save that way than it is to write a check to Vanguard,Schwab, Fidelity, with after tax money to invest in a index fund.

Yes, I guess we'll continue to disagree. The proposal is probably DOA (it's a tax increase), so we'll never have actual experience to see.

 

[clifp]

I think you're saying that the maximum DB benefit will continue to be indexed to inflation, but the cap on DC accumulations won't. I don't see how that's possible. Read the next paragraph.

No I am saying that annuity you get when you retired is a fixed amount $205,000 this year. I quoted how the cap is calculate an annuity with 100% joint survivor benefit but no inflation increase. While retiring on $205,000 is certainly a decent amount of money it isn't huge amount in 20 years if inflation kicks in.

Let's put this way all of those public employees with 100-150K pension that they can collect at say 55 with COLA have a better retirement than provided by the cap.

As we all agree this unlikely to become law so I am done.

 

[Independent]

No I am saying that annuity you get when you retired is a fixed amount $205,000 this year. I quoted how the cap is calculate an annuity with 100% joint survivor benefit but no inflation increase. While retiring on $205,000 is certainly a decent amount of money it isn't huge amount in 20 years if inflation kicks in.

Let's put this way all of those public employees with 100-150K pension that they can collect at say 55 with COLA have a better retirement than provided by the cap.

As we all agree this unlikely to become law so I am done.

Okay, you're saying the $205k is a fixed dollar benefit after retirement. So your complaint is that $205k isn't really very much money.

I'll agree that most people here figure that a safe spending plan for a $3.4 million fund starts at about $135K, and increases with inflation. So that's a more realistic view of the maximum tax-advantaged benefit.

That's about 3x the current median income for full-time, year-round workers. I suppose we could debate the public policy reasons for having tax-advantaged savings programs of any sort. You and I might be on opposite sides of that debate, but I'm afraid it would get us outside the boundaries of this forum.