Beware of Congress's Threat to Tax 401Ks

With the bear market red in the claw, with an equal opportunity bear market taking out solid stocks right and left, with panicked investors feeling like every headline is an explosion, comes this impenetrable stupidity:

Some Democrats in Congress have held hearings that included discussions of new proposals to tax 401K money. Specifically, the idea would be to eliminate most of the $80 bn in annual tax breaks that 401(k) investors receive. Which means a nearly $80 bn tax hike.

Heavy Retirement Losses

The idea to tax 401K funds comes at a time when the Social Security trust fund is deep in the red and investors have lost nearly half of their retirement savings--$2 tn--over the past 15 months, according to the Congressional Budget Office. Retirement accounts known as 401Ks had held nearly $5 tn in savings at the start of the year.

Democrats are expected to gain seats in both the House and the Senate in the coming election. A filibuster-proof 60-seat majority is a strong possibility in the Senate, which has historically been less receptive than the House to taxing retiree funds.

In early 1968 President Lyndon Johnson made a change in the budget presentation by including Social Security and all other trust funds in a "unified budget," which effectively let government use Social Security funds for its overall budget needs.

Gut-clenching Volatility

The Democrats' move comes as investor fear is rampant, as investors have been experiencing increasing acid reflux ever since the subprime crisis went viral in August 2007.

Wall Street is witnessing gigantic swings never before seen in the history of the stock market, with the S&P 500 Options Volatility Index (the VIX) repeatedly breaking through the unheard of 80 barrier, twice the 40 levels that were unthinkable even when oil hit $147 a barrel this past summer-making a VIX 50 the new VIX 40.

Congress's Support of Taxing 401Ks

House Democrats several weeks ago invited Teresa Ghilarducci, a professor at the New School of Social Research in New York City, to testify before Congress on her plan to eliminate the preferential tax treatment of 401K plans.

Specifically, Ghilarducci testified before the House Education and Labor Committee, chaired by Rep. George Miller, (D-Calif.), about her plan.

"We've invested $80 bn into subsidizing this activity," Miller reportedly  said in testimony, referring to tax breaks allowed for 401K contributions and savings.

With savings rates going down, "what do we have to start to think about in Congress of whether or not we want to continue and invest that $80 bn for a policy that is not generating what we ... say it should?" Miller reportedly said.

House Education and Labor committee spokesman Aaron Albright emailed to say that the notion that Rep. Miller wants to tax 401K money is "absolutely ridiculous," adding "chairman Miller wants to preserve and strengthen 401K plans, not tax them." 

Albright noted that the committee has called 11 witnesses, including retirement experts and advisors, over the last couple of weeks to assess the impact of the market's downturn on 401Ks. He added that the committee is looking at disclosure of fees that eat into savings, as well as other measures to strengthen 401Ks.

Rep. Jim McDermott, (D-Wash.), chairman of the House Ways and Means Committee's Subcommittee on Income Security and Family Support, has reportedly said that since "the savings rate isn't going up for the investment of $80 bn [in 401K tax breaks], we have to start to think about whether or not we want to continue to invest that $80 bn for a policy that's not generating what we now say it should."

The idea being that, despite their tax-deferred status, 401K funds are not doing much to add to the nation's savings rate.

Government Data Flawed

However, the government's measure of the US savings rate does not include stock market gains or real estate gains, which of course have been smacked hard during the credit crisis and economic downturn. And that means the government does not count in its official savings rate the $5 tn that was invested in 401K accounts at the start of the year.

The Expert's Tax Plan

The idea is to redirect 401K tax breaks to a new government system of guaranteed retirement accounts into which all US workers would be have to contribute.

Specifically, under Ghilarducci's plan, the tax breaks on 401K contributions and earnings would be eliminated.

Instead, all workers would get a $600 annual inflation-adjusted subsidy from the U.S. government. The sum would be inflation-indexed. Workers then would be forced to invest 5% of their pay in a guaranteed retirement account administered by the Social Security Administration.

That money in turn would then be invested in government bonds that would pay a teensy 3% a year, adjusted for inflation, less than half the inflation-adjusted 7% return the stock market has delivered.

"I want to stop the federal subsidy of 401Ks," Ghilarducci has said, adding, "401Ks can continue to exist, but they won't have the benefit of the subsidy of the tax break."

Tax Cuts Set to Expire

The idea to tax 401K accounts comes as a potential Obama Administration would let the Bush income tax cuts expire across the board.

That means even small businesses earning less than $250,000 a year would also see their taxes go up. The capital gains and dividend tax rates would also rise as well. Obama might also impose Social Security taxes on a higher level of wages and self-employment income.

Lower Taxes Help the Deficit?

As the US applies the paddles to the economy with record bailouts, a member of Congress during a recent hearing posed the question to Federal Reserve Chairman Ben Bernanke whether raising taxes during a downturn as a good idea. Bernanke's answer: No.

And experts say lower taxes actually help the deficit. Between 2004 and 2007, when the Bush tax cuts were in full flower, the budget deficit narrowed from $413 bn to $162 bn in large part thanks to rapid growth in tax revenue, the Economist Magazine notes.

This was caused not just by rising incomes, but also by a shift in the distribution of incomes to the wealthy, who pay the highest tax rates, the magazine says. Much of that wealth came from the credit boom which drove up financial profits, salaries and bonuses as well as property and stock values and related capital gains, it adds.

The US has added the equivalent of the gross domestic product of Great Britain and something like two Canadas and five Saudi Arabias since 2003. Between year-end 2002 and year-end 2007 U.S. growth exceeded the entire size of China's economy, Steve Forbes has noted.

However, Congress has virtually spent the amount in its bid to build a Supersize Me Government, spending that now sits squarely on the backs of taxpayers and entrepreneurs and which does not include the trillions of dollars in extra spending for the housing bailout and the bailout of Wall Street.

All proof positive that Congress has no more sense than a flock of geese.