Will the government shrink my 401(k)?

By Walter Updegrave, senior editor


(Money Magazine) -- Question: I'm increasingly concerned about the larger role the government has taken in our day-to-day lives in areas such as health care and banking and wondering whether this trend might eventually extend to 401(k) plans.

Could the government conceivably pass laws that dramatically increase the taxable percentage of 401(k) accounts to pay for its spending? Is there anything that can be done to avert this? -- Bill, Jackson, Mich.

walter_updegrave__2009b.03.jpg
Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

Answer: I can't say I've done a scientific survey. But I have noticed an uptick this year in the number of people who seem worried that government action of one sort or another might have a negative effect on their 401(k) plans.

I'd say the most-often cited anxiety centers on taxes, specifically the possibility that tax hikes will erode the after-tax purchasing power of 401(k)s. That sense of unease is hardly surprising. After all, tax rates will go up next year unless Congress prevents the Bush tax cuts from expiring as scheduled.

Besides, given the way the feds are spending, there's a growing sense that even if Congress holds the line on taxes now, we're in for higher rates down the road.

But this apprehension goes beyond taxes. Many people have also expressed concern that government meddling might somehow restrict participants' control over their 401(k) balances.

Warranted or not, I think this trepidation is at least in part a reaction to two retirement-related pronouncements from the Obama administration earlier this year.

Back in February, the administration released the first Annual Report of the White House Task Force on the Middle Class. Among other things, the report recommended further study of "the creation of Guaranteed Retirement Accounts (GRAs), which would give workers a simple way to invest a portion of their retirement savings in an account that was free of inflation and market risk, and in some versions under discussion, would guarantee a specified real return above the rate of inflation."

That same month the Department of Labor and Treasury asked for public comments about making it easier for 401(k) participants to access annuities and other guaranteed income products.

The language in the DOL's request seemed like the usual bureaucratic banal fare, noting mildly that DOL and Treasury wanted "to determine whether, and, if so, how, the Agencies could or should enhance, by regulation or otherwise, the retirement security of participants in employer-sponsored retirement plans and in individual retirement arrangements (IRAs) by facilitating access to, and use of, lifetime income or other arrangements designed to provide a lifetime stream of income after retirement." (To see the comments that came in, as well as the transcripts of two days of hearings on this issue, click here.)

But the reaction to these overtures has been anything but mild. In May John Boehner and seven other Republicans sent a letter to Labor Secretary Hilary Solis and Treasury Secretary Geithner expressing strong opposition to any move that would "dismantle or nationalize the private 401(k) system in favor of a government-run retirement security regime," including guaranteed retirement accounts (GRAs).

In the same letter, the group urged that DOL and IRS "take no action to mandate that plan sponsors...include a 'lifetime income' or 'annuitization' option...or that beneficiaries take some or all of their retirement savings in such an option."

You can find similar sentiments floating all over the Internet on various web sites and postings. I'd note that I also got a fusillade of angry feedback when I wrote a column earlier this year saying I thought it was a good idea to make annuities that generate lifetime income an option within 401(k) plans (although I added as long as they're not mandatory or laden with onerous fees).

So, getting back to your question, the issue is whether you should be concerned that government policy of various sorts might disadvantage your 401(k) and, if so, what you might do about it.

Let's start with taxes. I think it's perfectly reasonable to be concerned that a boost in tax rates might effectively shrink your 401(k). It's not as if Congress has been historically shy about income tax hikes.

Of course, even if tax rates do go up, that doesn't necessarily mean you would pay at a higher rate. That would depend on the structure of rates and your income when you begin pulling money from your 401(k).

Still, I think the possibility of giving up more of your 401(k) to taxes is high enough for most people to consider ways of protecting their retirement savings. That's why I've long advocated "tax diversification," or arranging things so your entire nest egg doesn't get the same tax treatment.

For example, money in traditional 401(k)s and IRAs is taxed at ordinary income rates at withdrawal (except, of course, after-tax non-deductible contributions, which aren't taxed). So if you have all your savings in such accounts and ordinary income tax rates rise, you could take a big hit.

But if you have some money in Roth accounts -- from which you can make tax-free withdrawals (assuming you meet the criteria) -- you would have a source of funds that wouldn't be hit with the higher rates.

To the extent possible, I think it's also a good idea to have some savings in investments that generate long-term capital gains, which are taxed at long-term capital gains rates, which are typically lower than ordinary income rates.

The point, though, is that having several buckets of money subject to different tax treatment allows you to hedge somewhat against tax uncertainty. Like any hedge, this one isn't perfect.

A future Congress desperate for funds could always come up with new tax schemes that subvert your planning. But it still makes sense to do what you can.

As to whether the government is likely to take other actions -- such as interfering with your investment decisions or replacing 401(k)s in whole or in part with some other retirement savings system -- that's a tough call.

If you consider the recent health care legislation, financial reform, the talk about GRAs, annuitization options, etc. as a prelude to a bigger government role in 401(k)s or retirement planning generally, then you'll see a threat.

For what it's worth, I'd be surprised to see any wholesale dismantling of the 401(k) system or fiats requiring 401(k) owners to convert some or all of their benefits into an annuity.

Even if someone in Congress or the executive branch were to make such a radical proposal, I'd say the chances are slim it would get past the formidable opposition it would likely encounter from 401(k) owners and others with a stake in the current retirement system.

But whatever you may believe, as a practical matter I don't think it would make sense to stop funding your 401(k) today because of such concerns. I mean, it's not as if any alternative you may switch to is somehow beyond the government's reach.

That said, I also think it's a good idea to follow these sorts of issues and, if you see initiatives that bother you, let the boys and girls in D.C. know where you stand (wherever that may be) when it comes to your retirement savings -- and tell them you're also ready to back that stand with your vote. To top of page

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