A Very, Very, Very Bad Idea!

Mrs. X and I were talking last night and I happen to mention an article that I glanced at yesterday. Apparently discussion on this article has taken off so I thought I would enumerate some of the major problems.

Essentially, a small group of Democratic Congressmen, spurred on by the economic theories of a professor, have idly discussed removing the tax-exempt status of 401(k)s and related tax shelters. Their reasoning goes that this is a large source of revenue that is being withheld from the government and that people are so scared by the volatility of the market that they want something safe. So the plan being proposed is that a person would put after tax money into a 401(k) and then the government would invest that money in government bonds at a guaranteed 3% interest. The investment money would then be given to the Social Security Administration to look over and they put a little checklist out that says you own x number of bonds that will be worth y when you plan to retire.

There are several very bad things about this plan. First, under the revised rules, the 401(k) assets would now be subject to the estate tax, giving the government the ability to take 50% of all unused assets when the owner croaks. Currently, since the 401(k) is a before tax holding, it only gets taxed when people withdraw the money and the holdings could be passed on in ownership without incurring any tax liability. But under this new plan, a 401(k) will be seen as a real asset and subject to the taxes that occur when it passes hands.

Second, since all the tax incentives will be withdrawn, employers will stop issuing matching funds to a 401(k). Currently, a company gains a massive tax write-off by giving matching funds to their employee’s accounts. But if there is no available tax write-off, a company doesn’t have any reason to give money away. So a person is losing as much as half of his potential retirement savings without the matching funds.

Third, since people are only allowed to invest in government bonds, ownership of stocks through mutual funds would crater. This in turn drives down the stock prices and the overall market as the number of people who have the ability to buy goes way down. Worse, it’s possible that the government may simply hold on to the shares that they have seized rather than put them back on the market. In effect, this would make the government the majority owner in thousands of freely traded companies and would give them the right to dictate whatever policy they saw fit for any type of company.

Fourth, we would all have to work longer because our retirements will simply not accrue enough money to support us. In 2005 and 2006, the average 401(k) earned somewhere between 7 and 15% depending on the overall aggressiveness of the fund. Yes, some of those profits have been lost, but over the life of nearly 40 years, the rate of return on stocks is much higher than 3%. This means that a person will not see anywhere near the rate of return that is being seen now.

Fifth, people will no longer have the amount that they donate to their 401(k) to take off the top of their adjusted gross income. Right now, a person has an overall gross income and that is adjusted downward based on the pre-tax donations that a person makes to their 401(k). That’s why you see one number that you use on your 1040 and a higher number that is used when noting how much you have paid to Social Security and local taxes. But if a person loses that tax-exempt status on their 401(k), the number that goes on your 1040 will now be the larger overall number. Effectively, this will push anyone who had a 401(k) into a higher tax bracket that what they had been and we will be forced to pay more taxes while saving a lot less money.

At its root, this proposal turns a means of promoting wealth and increasing collective ownership of companies into a government managed savings account. One that they can tap and spend at will, so long as they leave that promissory note called a government bond. However, if they ever go ahead with this plan, I guarantee that we will see the economy crater like no tomorrow and the 1930’s will have nothing on what will go on after this takes effect. Incidentally, Argentina is currently implementing this plan, so we’ll have an example to watch of how bad an idea this is.