Granada Tax Blog

Perhaps it is the way it is being presented, but President Obama’s proposal to limit retirement plan contributions appears widely misunderstood.

Under the 2014 budget subheading of “Strengthening the Middle Class and Making America a Magnet for Jobs,” readers see the administration’s suggestion to “Prohibit Individuals from Accumulating Over $3 Million in Tax-Preferred Retirement Accounts.”  It appears again in the 2015 budget under the subheading “Opportunity for All.”

Given that headline and the media’s generally incomplete coverage of the proposal, it may be beneficial to first recognize what this proposition most certainly does notstipulate:  It is not a “hard dollar,” lifetime accumulation limit of $3M.

Instead, a careful reading of the proposal indicates that an individual’s contributions to employer-sponsored retirement plans and IRAs would no longer be accepted once the aggregate balance reached “an amount sufficient to finance an annuity of not more than $200,000 per year in retirement…”

Any suggestion to limit retirement plan contributions, especially when governed by this type of language simply begs for additional scrutiny.

Annuities

An annuity is a contractual agreement, based in this case between an investor and an insurance company.  The investor exchanges their savings for the insurance company’s assurance of providing annual retirement income.

The administration suggests that for a current 62 year old retiree desiring a $200,000 annual annuity, a lump sum of $3-$3.4M would need to be exchanged with an insurance company today.  Hence the widely quoted “$3M limit.”  (To be clear, there is no suggestion that savers would need to annuitize their savings.)

Interest Rates

Insurance companies calculate the amount needed to purchase a $200,000 annual annuity based upon interest rates.  The $3M figure being cited is an estimate given current, historically low interest rates.  As interest rates rise, the amount needed to fund a hypothetical $200,000/year annuity predictably falls, thus reducing the aggregate retirement plan contribution limit below the $3M threshold in the headlines. 

Age

Second, an individual’s account balance isn’t simply compared to the stated threshold at age 62.  The amount needed to purchase the $200,000 annuity is significantly reduced with age.  Diligent savers could find themselves reaching a reduced maximum account value at a far younger age.  At present, the amount still appears excessive at roughly $1.3M for a 35 year old saver.  It is important to note that the projected $1.3M cap is based on current interest rates however.

Interest Rates and Age

In a normalized interest rate environment, a 35 year old would be limited to just a fraction of that amount as the combination of a younger age and higher interest rates substantially alter the proposed savings limit.  For example, at a 7% discount rate, the savings cap may be $340,000.  Given the latitude in calculating that amount, the figure is largely immaterial though the affect of interest rates to the proposed calculation shouldn’t be ignored.  To be clear, this proposal is not a $3M, lifetime accumulation limit.

Inflation

A $200,000 annual retirement income may seem comfortable, if not excessive for the voting public – as is likely the intention.  Enter the menace known as inflation, a variable that serves to quickly make large numbers far smaller than they initially appear.  For a 35 year old who assuming a 5% annual inflation rate, $200,000 in 30 years is equivalent to less than $50,000 today.   Make no mistake; this cap isn’t intended for only the rich and famous.

The intention here is not to make a political statement or even encourage political debate.  The intention is simply to ensure readers clearly understand the proposal and its potential impact.

The prospect of being prohibited from making additional contributions “across tax-preferred accounts” raises a host of tax and financial planning considerations.  Investors should be especially mindful of implications to income tax liability and an unaddressed potential loss of employer matching contributions.  In addition, adopting a more analytical approach towards evaluating pre-tax, Roth and post-tax 401(k) contributions appears increasingly prudent.