What a cap on 401(k)s could mean for wealthy savers

401k Retirement income tax
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The tax advantages of saving for retirement could be a limited-time opportunity for wealthy investors.

President Barack Obama's 2016 fiscal year budget includes a proposal to cap contributions to tax-preferred retirement plans like 401(k)s and IRAs. "While tax-preferred retirement plans are intended to help middle class workers prepare for retirement, loopholes in the tax system have let some wealthy individuals convert these accounts into tax shelters," the White House said. Under the proposal, individuals would be prohibited from contributing to or accruing additional benefits in such accounts once balances reach $3.4 million—enough, it estimates, to provide an annual income of $210,000 in retirement.

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Before you panic, take the news with a grain of salt: Financial advisors say the cap is unlikely to pass. "I used to react to proposals and then realized, heck, most of them never get passed, and the ones that do are usually altered," said certified financial planner Carolyn McClanahan, founder and director of financial planning at Life Planning Partners. "I've learned with politics, you worry about it when it actually happens."

401 (k) statement
Federal budget could hurt retirement savings   

Nor will most consumers come close to saving enough to be affected. The average 401(k) balance hit a record high last year—of $91,300, according to Fidelity Investments. Only 72,000 workers had a balance of $1 million or more, and of those, just 9 percent (roughly 6,480 people) had balances surpassing $2 million.

"I don't think the proposal is going to save that much money in terms of tax savings" for the government, said certified financial planner Clark Randall, founder of Financial Enlightenment in Dallas. "And any attempt to limit retirement planning sends the wrong message to consumers."

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For wealthier people, a $3.4 million cap will mean diversifying assets, a strategy those clients are already used to from bumping up against annual contribution caps. "People who have the ability to save, they're going to save it one way or another," said McClanahan. "They're just not going to get the tax benefit now." That might be municipal bonds, life insurance, annuities or a taxable brokerage account.

It's tough to gauge the impact of those lost tax savings, which would depend on how many more working years someone has before retirement to set aside funds and let them grow, Randall said. Many of the people with large 401(k) balances got there because they made big contributions, not because they made astute investments, he said.

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Details about how the proposal would be implemented are sparse—and those could further affect wealthy consumers. It's unclear, for example, if someone who amassed $3.4 million would be able to let it remain there and grow, or be forced to shift any excess from market gains into another savings vehicle, said McClanahan. Or if you could contribute more if portfolio losses dropped the total below that cap.

"The devil is in the details, and I haven't seen those details yet," she said.