American’s tax advantaged retirement accounts (i.e. the 401k and IRA) are unnecessarily complicated and unfair. As Washington debates tax reform, here is one potential method to simplify retirement savings accounts.
Generally, there are two primary retirement savings accounts, the IRA (for Individual Retirement Account) and the 401k (and its variations like 457/403b). As of 2017, an IRA has a $5,500 contribution limit and 401k’s have an $18,000 contribution limit.
All Americans (with earned income) can establish an Individual Retirement Account or “IRA”. However, not all Americans have access to a 401k because, among other reasons, they can be expensive for employers to establish and administer. A 401k can only be established by your employer and only about half of all employees have access to a 401k plan. This results in an unfair and inequitable system. Employees with access to a 401k are permitted to save $18,000 per year annually in a tax advantaged manner in addition to the $5,500 IRA contribution. An employee without access to a 401k may only contribute $5,500 to an IRA. In sum, an individual with access to a 401k can utilize tax advantage retirement accounts on up to $23,500 of income per year but an individual without access to a 401k can only defer taxes on $5,500 of income. This is not good policy and should be fixed.
Not only is availability of the 401k unfair, most 401k plans offer lousy investment options at considerable higher costs than what is available on the market in an IRA. Generally, an IRA allows for the purchase of any publicly traded stock, mutual fund, ETF, or index fund. However, a 401k will only allow investment in those mutual funds and index funds selected by your employer, likely as suggested by the 401k plan vendor. However, the cost of most actual 401k investments greatly exceeds a similar investment option available on the market particularly for small businesses. A simple S&P 500 passive index fund in a 401k likely costs 1.0% or more annually. This means that more than 1% of the entire amount invested is siphoned off by the administrator (not your employer) to manage the account. However, a similar S&P 500 index fund with an 0.05% annual expense ratio is available on the market and could be purchased in a Super IRA. Such fund has 1/20th of the cost of the same investment available in most 401k plans. The 401k’s restricted and expensive investment options are a primary factor in most personal finance professionals suggestion that an employee roll their 401k into an IRA upon leaving employment.
It does not have to be this way. Why not let current employees effectively roll over their current 401k to an IRA? This would allow those that like their 401k plan to keep their 401k plan and others to simply roll their 401k funds to an IRA each year. Better yet, why not remove this burden from the employer entirely and allow employees to establish a Super IRA with a combined contribution limit of $23,500. This ends the current unfair contribution limits and allows all employees regardless of employer to contribute the same amount to a tax advantaged retirement account. A single retirement account with the same contributions limits and rule promotes efficiency, simplicity, and fairness – which ultimately encourages adoption and retirement savings.
Of course there are some potential issue that will require resolution, like employer contributions subject to vesting and allowing payroll deductions. However, employers’ accounts could simply be segregated subject to the employer’s applicable vesting schedule and many employers already transmit employee’s 401k contributions electronically. The employee could simply submit a form to the employer along with his/her W-4 that directs the 401k withholding amount to the employee’s broker of choice (with ACH routing instructions, etc.). The funds could then be held in a money market account in name of employee subject to employee’s selection of specific investments through broker. The Super IRA could allow a portion of contributions to be ROTH contributions, which seems to be of some interest in Congress to provide short term revenue. (Roth IRA/401k contributions are made after taxes in the current year but grow on a tax free basis. This produces tax revenue in the short term as compared to a traditional IRA or 401k. Contributions to a traditional IRA or 401k are made prior to taxes but are taxed as income upon withdrawal.)
Undoubtedly, there may be other potential issues here, but we can do better than the current system. Although other issues may be more pressing, we should not continue the current unfair system where an employee with a 401k retirement plan can contribute about three time more to tax advantaged retirement accounts than an employee without a 401k.
Let’s revitalize retirement savings.