Although a now-small percentage of 401(k) plan participants with individual retirement accounts have combined balances that would subject them to a government-proposed cap on tax-deferred retirement savings accounts, the proportion of participants beholden to the limit could increase substantially over time.
The Employee Benefits Research Institute arrived at this conclusion in an August 2013 “Issue Brief” that explores the impact of a proposed federal cap on retirement savings. The report expands on an earlier EBRI analysis by simulating the 401(k) account balances at age 65 for all of the participants in the EBRI/Investment Company Institute (ICI) 401(k) database with salary information.
Earlier this year, the Obama administration proposed a cap on tax-deferred retirement savings as part of its fiscal year 2014 budget proposal. Under the proposal, a taxpayer who accumulates combined 401(k)/IRA retirement savings in an amount surpassing the total necessary to provide the maximum annuity permitted for a tax-deferred defined plan would be (at least temporarily) prohibited from making additional tax-deferred contributions or receiving additional account accruals. The taxpayer could resume plan contributions in later years if the actual rate of return on the accounts met an actuarial requirement of the proposal.
In its analysis, EBRI modeled the percentage of employees likely to hit a $3 million combined cap by age 65. Factoring in combined IRA and 401(k) balances as of year-end 2011 from an EBRI IRA/401(k) database for certain individuals age 60 and older, EBRI found that about 0.1 percent of plan participants already have cap-busting balances of $3 million or more.
However, the brief states that two variables — (1) a rise in the discount rate (the interest rate used to determine the present value of future cash flows); and (2) the plan participant’s age — would force a decrease actuarial present value of the proposed federal limit and, thus, lower cap limit.
The report observes that whereas a 25-year-old would be subject to an $800,000 cap given four percent effective interest rate, the cap falls dramatically to $132,000 when an eight percent discount rate is applied to the cap formula.
“Simulation results for 401(k) participants assuming no defined benefit accruals and no job turnover show that more than one in 10 current 401(k) participants are likely to hit the proposed limit sometime prior to age 65, even at the current historically low discount rate of four percent,” the report states. “When the discount rate is rerun with discount rate assumptions closer to historical averages, the percentage of 401(k) participants likely to be affected by these proposed limits increases substantially.
“[W]ith an eight percent discount rate, more than 20 percent of the 401(k) participants are simulated to reach the limit prior to retirement,” the study adds.
Read the full report here.