A couple of days ago, this article from Bloomberg hit the wires. Besides the near-miracle in itself that President Obama was preparing to submit a budget for the upcoming fiscal year (which assuredly will be voted down in bi-partisan fashion again), an interesting tidbit caught my eye:
“Obama’s budget plan, to be unveiled April 10, would prohibit taxpayers from accumulating more than $3 million in an individual retirement account.”
At first blush, some people may either think that this is a good idea, or think the “cap” is so far out of their reach that it won’t affect them — much like the “fiscal cliff” tax deal which raised the federal income tax on “the wealthy” that is now defined as a family making $450,000 per year.
In order to fully appreciate how bad of an idea this really is, allow me to present a rather crude history of the current state of retirement accounts in America.
In the 1970s, as corporations were facing bigger and bigger unfunded liabilities in terms of retirement costs, companies began to transition to essentially make retirement accounts the responsibility of the individual. In other words, the transition was made from defined benefit plans (often called “pensions”) to defined contribution plans (such as a 401(k)). In theory and in practice, this is a good idea from a standpoint of freedom and individual liberty. It rewards people who work hard and save their money. More importantly, it removes the concern that a company under-funds its pensions and leaves the workers who were depending on the pension to maintain a standard of living in retirement with empty pockets. If this sounds familiar, it’s because it’s similar to what we hear about Social Security.
In the late 1970s and early 1980s, Section 401(k) of the Internal Revenue Code became a focus of retirement planners because it permitted people to defer taxable income — meaning that they could receive a tax deduction now for contributing to a retirement account, invest their money, and pay taxes when they withdrew their money in retirement. There are caps on the amount one can contribute to a pretax 401(k) or an Individual Retirement Account (IRA) per year. An employee with a 401(k) plan can contribute $17,500 in 2013 towards a 401(k) and, depending on income, an individual can contribute $5,000 to an IRA and still receive a tax deduction. You can contribute more, but it carries different tax implications.
With this background, let’s examine how a young worker today would be affected if Obama’s proposed cap on retirement accounts is enacted.
First of all, it’s important to note that a $3 million retirement nest egg really isn’t a lot of money. I’m not a not one of the “one-percent.” But ironically, 1% is about the type of “safe” return one can expect in today’s super-low interest rate environment, thanks to the Federal Reserve’s money printing orgy known as “Quantitative Easing.” What is 1% of $3 million? $30,000. I live in New York City, and $30,000 per year isn’t a retirement income somebody dreams about. Even outside of New York City, when one factors in income tax on the $30,000, medical costs, property taxes, electricity, fuel, food, leisure, etc., $30,000 per year in gross income is nothing to write home about.
Another major concern here is inflation. Let’s assume a hypothetical worker is retiring this year, in 2013. Assume he began working 40 years ago, in 1973. The price of a gallon of gas was 39 cents per gallon. A gallon of milk would set you back $1.36. If he planned for retirement in 2013 using 1973′s prices, he’d be in trouble. Gas prices today are ten times than it was in 1973. Milk is three times the cost.
Here comes the $3 million question: Why should we care? Only rich people can afford to save $3 million, right?
Let’s assume our hypothetical worker is 25 and makes $1000 per week and is a diligent saver. Let’s assume he is able to save $300 per week and puts it into a 401(k) account. In addition, let us assume he’s able to achieve a 7% average return over 40 years (which is in line with what the stock market does over the long term). How much money will our worker have in 40 years, when he’s 65 and getting ready for retirement?
I used the government’s compound interest calculator located here to do that math.
But how does a guy who makes $1000 per week become a millionaire?
Simple: By saving.
The above example also assumes that: (1) he never gets a raise; (2) he never increases his savings per month; and (3) his employer never contributes or matches the employee’s contribution.
In other words, because time is on our worker’s side, he can hit Obama’s proposed retirement savings cap without being a “one-percenter.”
It’s unclear if Obama’s proposed cap is indexed for inflation or not. As we saw above, costs are rising over the long term and $3 million today could certainly be closer to what $1 million is in purchasing power today in 10, 20, or 30 years. Another concern is the proposed cap of $3 million could drop to $2 million or less in the future. Combine this with inflation and this will be the death-blow to personal retirement accounts.
Obama’s plan isn’t to attack “the rich.” It’s to punish people who save. There is no other way to put it. Even Bloomberg notes this proposal will generate only $9 billion in revenue over ten years. The government spends nearly $10 billion per day.
With Social Security projected to operate at a loss in the next few years, and becoming insolvent not too long after, why is our President proposing to attack responsible savers?