If you’re under the age of 40, you might not even be aware of the existence of a pension. Pensions, also known as defined benefit plans, used to be the principal source of retirement financing for most American workers until recently.
Pensions were totally under the control and responsibility of the employers, who would guarantee particular amounts to retired workers in the event of their incapacity.
Starting in the 1980s, pensions began to diminish rapidly as the defined contribution 401(k) plan took over as the dominant retirement plan. 401(k) plans, in contrast to pensions, do not provide fixed retirement payouts; instead, the amount of money received in retirement is determined by the performance of the 401(k) plan’s investments.
New rumblings from the Biden administration in 2021, on the other hand, raise the possibility that the 401(k) plan as we know it may be altered. Although the 401(k) plan is unlikely to follow in the footsteps of the pension plan, there may be significant changes in the near future.
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Pensions are on their way out.
From 1940 to 1987, the number of workers covered by a pension plan increased from 4 million to 40 million, representing a tenfold increase.
However, by the late 1980s, the 401(k) plan, which had been in existence since 1978, was moving forward at full speed, irrevocably altering the landscape of employee retirement.
A defined benefit plan was available to only 3 percent of full-time workers in March 2020, according to the U.S. Bureau of Labor Statistics, despite the fact that 67 percent of full-time employees had access to a retirement plan.
There are two key reasons why the 401(k) plan contributed to the abolition of the pension-dominated retirement plan era: first, it provided a viable alternative to traditional pensions.
First and foremost, companies were able to shift the burden of retirement funds, as well as the majority of the associated costs, to employees and retirees.
Employers no longer have to fund an investment account that may give lifetime payouts to their whole workforce; instead, they can simply set up 401(k) plans into which employees voluntarily contribute.
In spite of the fact that most major firms provide minimal matching payments to employee accounts, they are no longer liable for covering the entire cost of an employee’s retirement.
Second, 401(k) became increasingly popular because employees expressed a desire to contribute to their accounts. An employee who participates in a 401(k) plan has the ability to pick how much they want to contribute and what they want to invest in, rather than relying on their employer to make all of these decisions on their behalf.
Is the 401(k) on its way out?
The tax deduction that employees receive for making contributions to their 401(k) plans is one of the plan’s most recognizable features.
Combine this tax benefit with the investment options and matching contributions employees receive from their employers, and it becomes clear why 401(k) plans are so popular among employees and employers alike.
However, there have been rumblings from the Biden administration that they may modify this tax advantage in the near future.
Changes to the 401(k) Tax Deduction Proposed by President Biden
The idea put out by the Biden administration would convert the current 401(k) tax deduction into a tax credit.
In contrast to a tax deduction, which reduces your taxable income, a tax credit reduces your tax burden directly by reducing the amount of tax you owe on a dollar-for-dollar basis.
The Biden proposal would reduce the amount of this tax credit to a flat 26 percent across the board, regardless of your existing marginal tax band, and would be effective immediately.
Here’s why it’s significant. If you’re in the 37 percent tax bracket and make a $10,000 contribution to your 401(k) plan, you’ll be eligible for a $3,700 tax deduction at the time of writing.
Those in the lowest 10 percent tax band, on the other hand, would only receive a $1,000 tax deduction for the same $10,000 donation. According to the Biden proposal, any taxpayer who makes a $10,000 contribution would receive a $2,600 tax credit, regardless of their tax status.
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Is it possible that the 401(k) Plan may be phased out?
Even if the Biden administration is successful in implementing its suggestions, 401(k) plans are not likely to be phased out anytime in the near future.
In reality, for certain employees, the proposed modifications will result in a significant pay raise or bonus. Workers with high earnings are the ones who will be targeted by this idea, as their contributions currently result in greater tax deductions.
The Biden administration sees its proposed adjustments as “leveling the playing field,” as they would allow even lower-income workers to take advantage of the tax benefits that 401(k) contributions offer.
Furthermore, it may inspire these employees to begin contributing to a 401(k) plan, which will be beneficial to them later on in their working careers and during their retirement years.
