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Taxing 401(k) contributions would be disastrous for millennials

It's one of the possible tax reforms being (quietly) considered in D.C., according to a report.
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A little snippet from this Politico story on White House plans for tax reform has come under the microscope: a proposal to tax contributions made to 401(k) retirement plans.

Politico described it as "one idea quietly being discussed" in the White House. It would see people saving into a 401(k) workplace pension plan taxed on the money they contribute now, rather than when they withdraw it in retirement.

This would be an utterly disastrous change to what is currently the best retirement vehicle for savers (as I've written about in this Tip Jar column), and millennials would be particularly hard hit.

The Washington Post and DailyKos are also decrying any attempt to tax 401(k) contributions.

I can't imagine such an unpopular measure ever being implemented, but stranger things have happened. Here's why it'd be such a terrible idea.

It could cost people tens, potentially hundreds of thousands of dollars

Right now, 401(k) contributions are tax-deferred, so the money is taken straight from your salary before tax is applied, with the idea you pay tax when you withdraw it in retirement.

There are two big ways taxing 401(k) contributions would hit you big-time in the pocket.

1. You would lose the currently tax-free element of the money you save into your 401(k). This would not only reduce the amount you're saving by however much tax you pay, but also reduce the compound interest you accrue as that money is invested. Over the course of 30-40 years of saving (i.e. for current young workers), the loss could easily be six figures.

2. Your income in retirement will almost certainly be lower than when you're earning a salary, so if you pay tax now, you miss out on paying less tax as a pensioner.

It's a disincentive to save

Young people aren't saving enough for retirement as it is. Bloomberg reports only 41 percent of workers at companies offering 401(k) plans are contributing to one regularly.

And those millennials who do save into one aren't saving enough, with only 16 percent taking advantage of the full "match" offered by their employer, according to Business Insider.

Taking away the ability to save pre-tax would be even more of a disincentive to save for young workers, many of whom already have tight household budgets to deal with.

Taxing contributions now, rather than withdrawals later, would make 401(k)s little better than post-tax Roth IRAs, which should (where possible) be used as a complement to a 401(k) rather than as the main retirement vehicle.

Kicking the can down the road

Finally, the idea is being considered because it would be used to fund corporate and individual tax cuts now according to Politico.

I'm not going to get into the debate on who benefits from such cuts and who doesn't. But what I will comment on is the fact that the government would effectively be front-loading its tax contributions, getting tax revenue now instead of in 30-40 years' time when 401(k) holders are ready to withdraw.

This screams "gigantic budget deficit" decades down the line, something for – you guessed it – the current and upcoming generations of young adults to worry about.

Who's to say we wouldn't get to that point and circumstances are so dire that we are faced with the unthinkable? "Sorry, we have no money, we're going to have to tax your 401(k) withdrawals as well."

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