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Bad Math: Taxes Rise as Savings Fall

 

It’s time to rethink how much you’re saving for retirement and how you’re saving it.

For one thing, the recent budget deal in Washington (aka the American Taxpayer Relief Act) didn’t renew the so-called employee payroll-tax holiday. That means higher Social Security payroll taxes—and smaller paychecks—for nearly all wage earners.

At the same time, the new tax law lifted the restrictions on shifting money from regular 401(k)s to Roth 401(k)s, where contributions are made after tax instead of pretax, but withdrawals can be tax-free. (Earnings in regular 401(k)s are taxable when withdrawn.)

The payroll-tax increase hits average earners particularly hard and threatens to put a crimp in workplace retirement-savings accounts.

For the past two years, the employee share of the tax was reduced to 4.2% from 6.2% on the first $110,100 in earnings. This year, it snaps back to 6.2%.

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Mitch MacNaughton

Also, as previously announced by the Social Security Administration, the maximum amount of earnings subject to the tax rises to $113,700 this year, which alone increases Social Security taxes for nearly 10 million workers.

Those with wages above the taxable maximum are less affected by the tax, percentage-wise, than those with wages below the cutoff, who feel its full effect.

“For the five-figure wage earners, it’s a significant change,” says Stephen Horan, head of private wealth management at the Chartered Financial Analyst Institute. “People are more likely to cut back on savings than they are on spending.”

Joni Tibbetts, a vice president in retirement investor services at Principal Financial Group, provides an example of what could happen if you don’t budget for the 2% payroll-tax increase and instead cut your pretax 401(k) contributions.

A 30-year-old making $50,000 will see his take-home pay shrink $1,000 this year. If instead of cutting spending this worker puts $1,000 less into his 401(k) this year, he could have nearly $12,000 less by retirement at age 66.

If he doesn’t increase his savings rate over the next 36 years, the loss to his retirement account could approach $236,000. (And this isn’t even considering any employer matching contributions.)

If you were caught off guard by this year’s payroll-tax hike and are forced to scale back your retirement-plan contributions, Ms. Tibbetts suggests signing up for automatic annual savings-rate increases to get your contributions back on track as quickly as possible.

As for converting assets in a regular 401(k) account to a Roth 401(k), one obstacle is the relative scarcity of Roth 401(k) plans. Fewer than half of employers offering regular 401(k)s also offer the Roth version.

Beyond that, the pool of ideal candidates for conversion is relatively small: namely, young employees who expect to be in a higher tax bracket in retirement than they are now and who can afford to pay the income taxes they’ll owe upfront on the converted amount from nonretirement assets.

Mr. Horan suspects there is another deterrent at work here: tax risk—a possible change in the tax treatment of Roths.

Ever since the introduction of the Roth IRA in the 1990s, Congress has periodically made it easier for investors to convert pretax accounts to Roth accounts in the hopes of drumming up tax revenue in the short term—even though it does nothing to solve the country’s deficit problem long term.

Still, assets in traditional individual retirement accounts continue to dwarf those in Roth IRAs by a factor of 15, and fewer than 10% of employees offered Roth 401(k)s choose to use them.

“As much as Congress has been trying to encourage people to take that tax bite upfront, people have trouble pulling the trigger,” Mr. Horan says.

Perhaps they’re afraid that 20 years from now Congress will change the rules regarding Roths. Remember in the 1980s when they started taxing Social Security benefits? There’s nothing preventing them from doing something similar with Roth distributions.

What to do? “When you’ve got uncertainty, create options for yourself,” says Mr. Horan. “Have a portfolio of accounts much like you have a portfolio of securities so that you can adapt to changing tax laws as time goes on.”

In other words, don’t put all your retirement eggs in one tax-sheltered basket.