Good Intentions, Bad Policy On Retirement Savings

Too many Americans face a future retirement for which they will have too little in savings. Is this because they raid their retirement savings along the way – or is it because they do not save enough in the first place?

The answers to those questions are “yes” and “yes.” However, in a classic example of shooting at the wrong target, Sens. Herb Kohl and Mike Enzi have submitted legislation that would make it harder for workers to borrow the retirement money they have set aside in their 401(k) plans.

Kohl, a Wisconsin Democrat who is not seeking re-election next year, and Enzi, a Wyoming Republican, introduced the “SEAL 401(k) Savings Act” on Wednesday. Kohl wants to stop workers from using 401(k) plans as “piggy banks,” according to Bloomberg News. The theory seems to be that this will encourage workers to leave their retirement accounts alone and find other sources of funds to satisfy current spending needs.

The reality is that, in most cases, there are no other sources of funds, or at least no sources that do not carry exorbitant credit-card interest rates and impose other serious burdens. Money in a 401(k) is money that workers have already earned. If we fence it off too thoroughly, we are not going to encourage workers to leave money in these plans; we are going to encourage them not to put it in 401(k) plans in the first place. Thus, the Kohl-Enzi solution to the retirement savings problem is likely to make the problem worse.

We need to get people to save more, period. Not just for retirement, but for the other needs that can be just as important.

Can we tell a 35-year-old breadwinner that keeping retirement funds untouched is more important than putting a new transmission into the car that the breadwinner uses to get to work? Or paying for a child’s braces or eye doctor? Or getting into a serviceable home in a good school district?

I don’t think so. Even though I believe devoutly that saving for retirement should begin as soon as we enter the work force, we have to be realistic. Life throws a lot of surprises at us. Our financial arrangements have to be flexible enough to deal with those surprises. That is why 401(k) plans, and other retirement saving vehicles, can be tapped early.

So why don’t people save enough? There are many reasons, but a big one is that there is presently very little incentive to do so. The government and the Federal Reserve keep interest rates artificially low to benefit borrowers. The idea is that this will stimulate the economy. But we’re creating a nation of consumers, not savers, and this will have detrimental long-term effects.

In a 401(k) arrangement, employees voluntarily divert some of their wages into the plan. The employer typically matches all or a portion of the employee’s contribution. The employee does not have to pay income taxes on the diverted salary or on the employer’s match until the money is withdrawn. Employers can take an immediate deduction for the employee and employer contributions. The net effect is that, in the interest of encouraging retirement savings, the government gives up some tax revenue now, with the expectation that it will eventually receive the taxes when the money comes out of the plan.

A 401(k) is part of a bigger category of retirement vehicles known as profit-sharing plans. At Palisades Hudson, we have a profit-sharing plan that does not require employees to make contributions. Instead, I decide every year what percentage of the prior year’s compensation will be contributed on behalf of our participating employees. The tax rules are the same, but employees have no direct say over how much I contribute. They do have an indirect voice, however, because the alternative to making a big profit sharing contribution is to pay bigger salaries or bonuses that employees can spend today. If I skew too heavily toward retirement savings, our staff will be unhappy, and some may even leave.

Once money is in a 401(k) or other profit-sharing plan, employees generally try not to withdraw it. There is a 10 percent penalty, in addition to regular income taxes, payable for most withdrawals before age 59½, except in some limited hardship circumstances. This is enough to deter most people from breaking into their 401(k)s to pay for flat-screen TVs or cruise vacations.

But many workers will encounter real financial needs before they hit 60, and not all of those will qualify for hardship exemptions. If they cannot pay the taxes and penalties on a withdrawal, there is another option. It is possible for the employee to borrow against his or her own 401(k) account, generally up to 50 percent or $50,000, whichever is less. The employee then repays the loan through payroll deductions. If the loan is repaid in full on time, no tax penalties occur.

A problem arises where workers leave their jobs, voluntarily or otherwise, before the loan is repaid. Employers can no longer deduct repayments from wages, so the entire balance of the loan usually comes due. According to Bloomberg, almost 70 percent of borrowers in this position default. The unpaid balance then counts as taxable income, and if the borrower is under 59½ , the 10-percent penalty also applies.

The Kohl-Enzi legislation, in seeking to reduce this outcome, would cut the number of permitted simultaneous loans per borrower to three, though it is unclear why five $10,000 loans are somehow worse than one $50,000 loan. It would, more helpfully, extend the time participants could have to repay their loans after losing a job, which may indeed lower the rate of default. It would also ban debit cards linked to 401(k) accounts. Debit cards are simply a cash delivery method. Why not require pre-retirement distributions to be sent via carrier pigeon, while we’re at it?

Kohl and Enzi are correct that people look at their 401(k)s as financial backstops. When an employee chooses how much salary to divert into the plan, the employee takes into account how much, if any, of that money will be available in the event of a pre-retirement emergency. If employees know that the retirement money will be harder to tap, they are going to put less money away from retirement in the early years of their career, when that money has the best chance to grow for the long term.

It would make more sense to encourage saving for all sorts of purposes, not just for retirement or for health care or for nursing homes or for college, all of which have their own special tax-favored arrangements. We could simply create tax-favored accounts that are good for any sort of savings. If we don’t want to disproportionately favor the wealthy, we could cap annual contributions to such plans to a set amount, perhaps $5,000 or $10,000.

If you want to get more people into the savings pool, the answer is not to put a higher fence around the pool. It is to make the pool bigger and more appealing. The Kohl-Enzi approach has a worthwhile aim, but it misses the mark.

About Larry M. Elkin 525 Articles

Affiliation: Palisades Hudson Financial Group

Larry M. Elkin, CPA, CFP®, has provided personal financial and tax counseling to a sophisticated client base since 1986. After six years with Arthur Andersen, where he was a senior manager for personal financial planning and family wealth planning, he founded his own firm in Hastings on Hudson, New York in 1992. That firm grew steadily and became the Palisades Hudson organization, which moved to Scarsdale, New York in 2002. The firm expanded to Fort Lauderdale, Florida, in 2005, and to Atlanta, Georgia, in 2008.

Larry received his B.A. in journalism from the University of Montana in 1978, and his M.B.A. in accounting from New York University in 1986. Larry was a reporter and editor for The Associated Press from 1978 to 1986. He covered government, business and legal affairs for the wire service, with assignments in Helena, Montana; Albany, New York; Washington, D.C.; and New York City’s federal courts in Brooklyn and Manhattan.

Larry established the organization’s investment advisory business, which now manages more than $800 million, in 1997. As president of Palisades Hudson, Larry maintains individual professional relationships with many of the firm’s clients, who reside in more than 25 states from Maine to California as well as in several foreign countries. He is the author of Financial Self-Defense for Unmarried Couples (Currency Doubleday, 1995), which was the first comprehensive financial planning guide for unmarried couples. He also is the editor and publisher of Sentinel, a quarterly newsletter on personal financial planning.

Larry has written many Sentinel articles, including several that anticipated future events. In “The Economic Case Against Tobacco Stocks” (February 1995), he forecast that litigation losses would eventually undermine cigarette manufacturers’ financial position. He concluded in “Is This the Beginning Of The End?” (May 1998) that there was a better-than-even chance that estate taxes would be repealed by 2010, three years before Congress enacted legislation to repeal the tax in 2010. In “IRS Takes A Shot At Split-Dollar Life” (June 1996), Larry predicted that the IRS would be able to treat split dollar arrangements as below-market loans, which came to pass with new rules issued by the Service in 2001 and 2002.

More recently, Larry has addressed the causes and consequences of the “Panic of 2008″ in his Sentinel articles. In “Have We Learned Our Lending Lesson At Last” (October 2007) and “Mortgage Lending Lessons Remain Unlearned” (October 2008), Larry questioned whether or not America has learned any lessons from the savings and loan crisis of the 1980s. In addition, he offered some practical changes that should have been made to amend the situation. In “Take Advantage Of The Panic Of 2008” (January 2009), Larry offered ways to capitalize on the wealth of opportunity that the panic presented.

Larry served as president of the Estate Planning Council of New York City, Inc., in 2005-2006. In 2009 the Council presented Larry with its first-ever Lifetime Achievement Award, citing his service to the organization and “his tireless efforts in promoting our industry by word and by personal example as a consummate estate planning professional.” He is regularly interviewed by national and regional publications, and has made nearly 100 radio and television appearances.

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