President Barack Obama's budget for fiscal year 2014, released Wednesday, is loaded with an unusually large number of carrots—and sticks—for U.S. workers' retirement savings.
The idea getting the most attention among retirement-industry leaders so far is a lifetime cap on savings in individual retirement accounts and other tax-deferred retirement-savings vehicles, including 401(k) plans and corporate profit-sharing plans.
Here is how the proposed cap works: A saver's total balance across such accounts would be limited to the amount needed by a 62-year-old to buy an annuity generating an annual payment of $205,000.
The formula, based on the maximum annual payment allowed in traditional pension plans, means the total would vary from year to year depending on the cost of such an annuity. The cap, if in effect this year, would be about $3.4 million. Once the cap is reached, the saver couldn't make any additional contributions unless the total account value fell below the cap or the cap increased.
The repercussions could be significant. U.S. corporations have been largely phasing out traditional pensions and replacing them with 401(k) plans, on which many higher-income workers plan to rely for retirement income. Meanwhile, two out of five U.S. households hold IRAs.
Financial advisers already are starting to warn clients they might need to rethink their savings and estate-planning strategies.
Of course, it isn't clear at this point how many of the proposals will see the light of day. A few have been stuck in Congress, in one form or another, for years. But with lawmakers' increasing focus on drumming up new sources of revenue, it's well worth keeping an eye on what is being floated.
Here's what is on the table, along with some ways to react if the changes are enacted.
The cap on tax-deferred retirement savings is designed to stop "wealthy individuals" from accumulating "many millions of dollars in these accounts, substantially more than is needed to fund reasonable levels of retirement saving," the budget document says. It estimates that placing limits on total account balances could raise $9 billion from 2014 through 2023.
Republican presidential candidate Mitt Romney, for example, disclosed during the campaign that his IRA was at one point worth more than $100 million. A spokeswoman for Mr. Romney declined to comment.
The federal government already has strict limits in place on the amounts that can be contributed to retirement accounts, but sometimes assets contributed to IRAs later increase markedly in value, providing the investor with a big chunk of tax-deferred earnings.
The contribution limit this year for individuals under age 50 in 401(k)s is $17,500, and up to $51,000 for worker and employer contributions combined. The limit for IRAs is $5,500. (Older savers can make catch-up contributions as well.)
The danger for rank-and-file workers, whose account balances typically fall under the proposed cap, is that the people who would be among the most affected by it—business owners and other successful investors—could disband 401(k) plans for all employees and move money into other tax-sheltered tools, retirement-industry experts say.
Under the proposal, "the small-business owner can't just put $50,000 into his own account," says Brian Graff, chief executive of the American Society of Pension Professionals & Actuaries in Arlington, Va. Even after following complex federal rules requiring employer plans to pay proportional benefits to all workers, business-owners are now being told, "Sorry, you've saved too much," he says.
With no tax deferral for additional contributions once they reach the cap, some small-business owners might consider ditching their 401(k) plans altogether. "If this legislation were enacted tomorrow, we would probably deactivate our plan," says Joe Nealon, a partner in Pacific Western Lumber, a Lakewood, Wash., lumber-trading company.
Of course, businesses might decide to keep their retirement plans as an incentive to attract or retain workers. But in the case of smaller businesses in struggling industries with a large concentration of older executives in the plan, like Pacific Western, keeping a plan might seem like more trouble than it is worth.
Mr. Nealon, 66 years old, works with handful of long-term partners also in their 60s who "have worked hard to get our individual accounts to a point that is near the threshold they're talking about," he says.
"If there was no longer a tax benefit to our 401(k) retirement plan, it would throw it into serious jeopardy," he says, because it would be hard for the business to justify the expense and hassle.
Some observers contend that any income tax generated now from the proposed changes could mean less tax revenue that could be collected later.
The proposal "simply doesn't raise revenue," says Ronald O'Hanley, Fidelity Investments' president of asset management and corporate services. "It shifts it from the future to the present."
If your workplace plan shuts down, your employer would typically help you roll your assets into an IRA to preserve your tax deferral. If your savings were below the proposed cap, you could continue making contributions to the account, although the maximum amount allowed would be subject to the lower IRA limits.
• If you are near the limit, find another tax shelter.
How else could you invest retirement assets beyond the amount you would need for living expenses? Instead of investing in an IRA, retirement savers wary of exceeding the cap could buy variable annuities, which also defer taxes on earnings. Such products, though, often have higher fees than those on many investments offered in IRAs and 401(k) accounts.
Another possibility: withdrawing a large chunk of your IRA, paying any income tax owed and using what is left to buy life insurance. If the insurance policy is owned by a trust, the payout could go tax-free to your heirs, says Ed Slott, an IRA consultant in Rockville Centre, N.Y.
• If you are younger, sit tight for now—but keep an eye out.
At the moment, a $3 million-plus cap would affect only a sliver of retirement savers—about 0.1% of people age 60 or older with at least one IRA or 401(k) account in 2010 and 2011, according to the Employee Benefit Research Institute, a Washington nonprofit research group.
But the budget proposal isn't tied to a specific dollar figure, EBRI points out. Instead, it is based on the amount needed to generate an annuity payment of $205,000 a year for a 62-year-old worker in a traditional, defined-benefit pension plan. If interest rates rise, annuities could get cheaper, meaning the cap could shrink. Going back to late 2006, for example, annuities paying that amount cost as little as $2.2 million for someone age 65, says Jack VanDerhei, EBRI's research director.
With a $2.2 million cap, 5.2% of workers aged 26 to 35 with five to nine years on the job and 401(k) accounts would be affected at age 65, he says. Some 9.2 million people in that age group now have 401(k) accounts, according to EBRI.
• Look for ways to save on autopilot.
The budget calls for automatic enrollment in IRAs for the 78 million workers, about half the U.S. workforce, who aren't offered an employer-backed retirement plan. (Workers could opt out, and businesses with 10 or fewer workers would be exempt.)
For small-business owners who have been reluctant to add another administrative expense, there is a new proposed perk: Employers could get a tax credit of $25 a year for each participating employee, up to $250 a year, for six years. And the tax credit would double to $1,000 a year, for four years, for small employers starting new retirement plans.
Workers at small businesses wishing for an automatic way to invest part of their paycheck for retirement may want to point out the possibilities to their employers as well.
• Be wary if you are using an IRA to pass tax-free money to your kids.
Under current rules, people who inherit IRAs can "stretch" their withdrawals across their life expectancies, paying income tax only on the amounts they remove from the account and continuing the tax deferral on any earnings inside.
But the budget proposal would force heirs other than spouses to empty such retirement accounts within five years, raising almost $5 billion in 10 years, it estimates.
The possible move, which has been floated previously, "makes more sense than a cap, because it's making the point that retirement accounts were never meant as an estate-planning vehicle and it would accomplish basically the same thing," Mr. Slott, the IRA consultant, says.
It also means older investors should think hard before converting IRA assets to Roth IRAs. Paying income tax on an account's value now to move its assets into a Roth, on which future withdrawals and any earnings generally are tax-free, even for heirs, has been a popular move for well-heeled older investors hoping to leave the accounts to their children.
But if stretching those withdrawals beyond the five-year point is no longer possible, older parents will have less incentive for paying the tax to turn those accounts into Roths, says Jeffrey Levine, a certified public accountant who works with Mr. Slott.
• If you have a small IRA, you could get a reprieve from mandatory distributions.
The budget proposal exempts IRAs and other tax-deferred retirement plan balances worth $75,000 or less from the complicated rules for taking the required annual withdrawals that account holders have to follow starting the year they turn 70½ years old.
That move could be particularly welcome among older investors, as the Internal Revenue Service is gearing up for a compliance effort starting later this year, according to a March letter from an IRS official to Rep. Steve Israel (D., N.Y.). One goal of that effort is to stop IRA owners from failing to take such withdrawals.
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