And now: another squeeze on your ability to retire

Americans are not particularly financially literate, and that may be a help to Republicans who are trying to get a tax “reform” package through Congress.

We tend not to save for retirements and with the proposed lowering of the contribution limit to $2,400 for 401(k) plans, that’s not going to be a situation that’ll improve.

With pensions being so yesterday, and Social Security likely failing tomorrow, the 401(k) is one of the few tools Americans have to have something available when they retire. Their deductions from their paychecks aren’t taxed until they withdraw them, presumably when their tax exposure would be smaller late in life.

It’s a sweet deal. So why change it? By giving the wealthy a tax break under “reform”, the Republicans need that money taxed now.

There’s really nothing in it for anybody else.

On, Al Zdenek, CPA, founder and president/CEO of Traust Sollus Wealth Management, does the math:

Let’s say a 40-year-old person saves $18,000 in a 401(k). Assuming an average annual return of 6 percent, by the time he or she reaches age 65, this one-time contribution will grow to about $77,000. If the money had not been placed in a 401(k) but rather in a mutual fund or other investment outside of the plan, the account holder would have had to pay tax on the $18,000. Assuming the effective tax rate between federal and state is at least 25 percent, he or she will pay $4,500 in taxes, leaving only $13,500 to grow for retirement.

Worse, the 6 percent return would also be taxed. So, the account holder might wind up only earning 4.5 percent, or 25 percent less, due to taxes each year.

That $13,500 dollars growing at 4.5 percent for the same 25 years would result in a total of a little more than $40,000, or $37,000 less than if the funds grew in the 401(k). This is 48 percent less wealth the person would have for retirement even though he or she lost just 25 percent in savings and in earning power due to taxes.

This, of course, is the power of compounding.

It’s hard to see a lot of clamoring among working people for the idea.

If they’re smart, they’ll still put the money away for retirement, but with it being taxed, their take-home pay goes down. That stimulates the economy, how, exactly?

As the New York Times reports, it’s about getting a deal — any deal — done.

But the proposal has its fans. Basically converting 401(k)’s to Roth IRA’s could still give the saver a tax break. Later.

Andrew Biggs, formerly a principal deputy commissioner of the Social Security Administration, said that for most people, it makes little difference whether they pay taxes on retirement savings now or in the future. Automatic enrollment and the employer matches are much more important than the delayed taxes, said Mr. Biggs, now a retirement specialist at the conservative American Enterprise Institute.

Some studies have confirmed his hunch. One team of researchers looked at a handful of companies that offered a tax-deferred savings plan and then added a Roth option to the menu. They found the total amount of contributions didn’t change much. “The tax deduction was a pretty minor force,” said James Choi, a finance professor at the Yale School of Management and a part of that team.

And depending on future tax law, Mr. Choi said that retirees with Roth accounts could get by with smaller contributions than those with 401(k)’s because they won’t have to pay as much tax on the savings they withdraw.

But it still doesn’t solve the fundamental problem: Too many people are facing retirement — either voluntary or forced — with no savings and little prospect that Social Security and Medicare will see them through.

There’s no deal coming anytime soon that will fix that.