With Congress set to change parties in 2023, a return to gridlock will likely be a defining feature of the rest of the current presidential administration. Yet before the Democratic House of Representatives leaves, they found time to agree with their Republican colleagues enough to pass the Secure 2.0 Act.

The Act is part of a $1.7 trillion budget bill that includes the revamp to retirement savings which was agreed to on a bi-partisan basis. What this primarily affects is the self funded employee pension program known as the 401(k). For civil service and non profit employees, the same vehicle is called a 403(b) but for the purposes of this post I will refer to the private pension changes collectively as the 401(k).

Below I’m going to summarize the main changes to the current program. Stating these changes on their own isn’t exciting or interesting. What is a bit more engaging is why the system is being changed as it is and how regular folks can benefit from it.

The state of retirement is often much maligned in the US, so I will also cover a bit on how the changes and the overall system compare to that of other countries, especially one regarded as one of the top retirement systems in the world: The Netherlands.

The Changes to the 401(k)

• In 2023 those who have earned sufficient income can contribute $6,500 in contributions to an IRA or Roth IRA. This increases to $7,500 for those 50 or older. In 2025, those 60 to 63 will be able to contribute $10,000 extra.
• The required minimum distribution age will also change. Right now it sits at 72 but that will increase to 73 in 2023 and 75 in 2033.
• Employers will be required to auto-enroll employees in 401k plans and contributions will start at 3% of employee salaries and increase 1% every year until they reach 10% of earnings.
• There will also be the creation of an emergency savings account where employees can stash up to $2,500 with matching from employers. These will be able to be tapped 4 times a year penalty free.
• Employers will now be able to provide the match even if employees aren’t making contributions.
• The savers tax credit is being channeled into government matching. This will mean for moderate and low income individuals, the government will match retirement contributions up to $2,000.
• The bill will also allow to expand the circumstances of when you can tap the funds early: these range from terminal illness to domestic abuse.
• Roth accounts will also be changed. After 2025, required distributions will be eliminated. Those 50 and over will be able to contribute an additional $1000 (the $7,500 mentioned earlier) and this will be indexed to inflation. In 2023 the limit will be $6,500 and $7,500 for those over 50.
• Finally, one of the big changes will be for those that have had a 529 plan for 15 years or more, a maximum of $35,000 will be allowed to be rolled into a Roth IRA account.

Essentially these changes allow someone to work for longer, delay distributions and contribute more at an older age. The changes acknowledge a reality: too many people are waiting until it is very late into their working lives to start significantly contributing to their retirement.

The statistics are not encouraging. The average social security payout in the US is $1,632 a month or $19,584 a year. To be fair, this includes those on disability or those who have taken social security early which reduces the size of the payments. For those who take it at 65 the average payment is $2,484 a month or $29,806 a year. Again, not a figure that breaks the bank but something that helps.

Just about any financial advisor would counsel to not rely solely on social security. In the past it was supplemented with a pension many received from an employer. These tended to be what are called defined benefit schemes. They usually worked on the idea that if a worker was employed at a company for a certain number of years, they would then vest into a system which would guarantee a payout in retirement. This benefit would increase based on years of service. Once a worker was vested, it was primarily up to the company to take care of the investing, risk and return. Yet there was a problem with this system.

Why Many Companies Moved Away from Traditional Pensions

These systems proved to be expensive for corporations for a number of reasons which included: they made them less competitive and they were hurt by economies of scale. While I don’t want to get too into the details of this, longer lives and aging demographics in the US hobbled many companies with legacy pension systems that proved expensive and made them less competitive in the global market. The famous example being car manufacturers which were crippled by pension liabilities.

Economies of scale also make sense. It tends to be more efficient to have a few expert managers managing people’s money rather than a pension manager at every medium or large sized company.

The result of this is that employers tended to move to defined contribution plans, which is where the 401(k) comes in. This allows the employer to not have to take on the risk of how the investments perform but it places a lot of responsibility back on the employee to manage their own finances, something which can be daunting to many.

State of the 401(k)

Right now, the average and median 401(k) doesn’t look all that promising for the average American. The average balance is $141,552 and the median balance is $35,345. But this can be brought down by a younger population. A breakdown by age is more telling:

Even if we assume that many nearing retirement age are at the high end of the median at $62,000, this adds about the only $5,000 a year in income for those after 65 if life expectancy in the US is around 77. It’s no wonder that many are choosing to work into their older age to pad some extra income on as they live longer.

This is the logic behind many of the changes to the 401(k) rules. They allow those working while older to delay required payouts even later, convert some college savings to retirement savings, encourage avoidance of tapping retirement funds directly while young and enroll workers automatically to get them involved in the system early.

Despite some pessimistic viewpoints that these are driven by the financial lobby, these changes are positive for savers and retirees. Yet both the advantages and the flaws of the American system lie in its flexibility.

The US pension system gives workers enough rope to hang themselves with, and sadly they often do. A consumer driven society seems to be eschewing a comfortable retirement for the dazzle of the now. At the same time, the freedom and flexibility it offers, creates immense opportunities for those that learn how to use it and are disciplined enough to execute on it. Workers essentially have a tax shelter which, although it has many restrictions about when it can be tapped, can offer fantastic opportunities to live very well in retirement and pass on significant legacy assets to heirs, many times completely free of taxes.

The most famous recent example of this is the case of Peter Thiel’s Roth IRA account, where he placed private securities of what was to become PayPal into a Roth Account which then ballooned to a $5 billion valuation when the company eventually went public. This means Thiel will never pay taxes on that $5 billion after he turns 60, which is next year.

Savvy Small Investors

You don’t have to be a billionaire to take advantage of these changes though. The real power of these changes can be harnessed by those who live long and are savvy with their finances. For example, since Roth IRA’s now have no minimum distribution they can grow indefinitely. These accounts can also be transferred to surviving children upon death.

Once that happens, as long as the Roth account is 5 or more years old, surviving children can receive all of the distributions tax free over a period of 10 years.

To understand the potential of this, an example helps. Consider someone who started saving around 30 and decides to put away the maximum into a Roth every year until they pass away at 80.

For simplicity’s sake let’s ignore the $10,000 you can contribute from 60 to 63 and just assume this person contributes $6,000 a year until they are 50 where they then contribute $7,500 a year thereafter until they are 80.

Let’s also assume this person is a risk taker and invests in small and mid cap stocks along with the S&P 500 index, achieving a 10% annual rate of return.

By age 50, this person’s Roth IRA has grown to $343,650. Not terrible, and more than most today have for retirement, but not mind blowing.

However, when this person keeps at it and starts putting away $7,500 a year for the next 30 years, their investment grows to an astounding $7.23 million. Now this is on a nominal basis, taking inflation into account at a rate of 2% this is $2.7 million in the dollars of that original 30 year old. Keep in mind that I never adjusted those contributions for inflation either so the number can reach even higher as the contribution limits adjust higher with inflation.

This represents a significant legacy that this mildly prodigious saver can leave to their offspring with very minimal effort and never having to earn more than $100,000 in any year of their lifetime.

So Why is the US so Bad?

Despite the scary statistics and somewhat depressing reality that many are underinvested for retirement, the US isn’t actually a terrible place for retirement and pensions. The Mercer CFA Global Pension Index ranks different national pension systems across the world and the US usually falls within the top 15.

The highest spots in these indexes usually fall to one of 3 countries: The Netherlands, Iceland and Norway. Norway has oil wealth which buttresses its system so I don’t want to focus on that one but the Netherlands is a small country with few resources yet seems to often rank as one of the top systems in the world. So I was curious how their system worked and why it’s praised so highly. In addition, how does this system differ so much from the US?

The Netherlands has a concept similar to social security called the AOW. The AOW is indexed to the state minimum wage. A married couple can receive the full minimum wage on retirement of €1,756 a month ($1,879) and a single person can receive €1,229 ($1,315). Not that different from what many receive for social security in the US and in many cases less.

The price for this is very high however. It takes a 17.9% tax out of workers’ paychecks to pay for this. Much higher than the 7.65% that is taken in the US for Medicare and social security.

The other leg of the system is employer provided pensions. These operate as non-profits and most employers offer them. They accrue according to a schedule of 1.875% of annual salary per year worked. This number is backed out of a calculation for which if someone works for 42 years, they should be able to replace 70% of their annual income by retirement. By 2024, that retirement age will be pushed up to 67 and 3 months. Employees contribute approximately 4% – 7% of their salary towards this pension.

This is the leg that is most similar to the 401(k) program in the US and doesn’t differ dramatically in contributions. In the US employers typically match 2% – 4% in employee retirement accounts and the new rules will auto-enroll employees at a 3% contribution rate.

The third leg are private pensions where employees can save extra on their own. This has restrictions on age and taxes similar to other programs but with the flexibility that a private option offers.

Now these rankings often rank these systems on macro factors that aren’t as important on an individual level. Most retirees could care less about government debt levels or bank non performing loan levels, all of which are used to rank the global pension systems. The ongoing sustainability of the system is important on all levels and the Dutch are praised for that factor especially.

The Dutch even seem to pay a lot more for a system that gives them even less. Their state pensions are lower than many receive for social security while taxes are very high. A 17.9% tax plus adding another 7% on top of that for your own savings means that almost a quarter of your pay is going towards yours or someone else’s retirement, and that’s before the government even gets their cut.

It seems that the primary difference between the US and the Dutch systems are that employees have more control of the private pension pot through their 401(k) and they aren’t automatically enrolled and contributing at every job like employees are in The Netherlands. These new changes to the 401(k) will attempt to alleviate some of those issues and hopefully increase the well being of more Americans in retirement.

In fact, even the Dutch have acknowledged that their system will need to change with a changing global economy and changing demographics. The country recently passed legislation that moves more towards an American style 401(k) model where each employee can see and is responsible for their own retirement contributions. This change was deemed necessary to keep up with the burden of an aging population and the demographic change it will bring.

So rather than lament the changes to the system, know that even the best systems are changing as well. For once Congress was able to get together and make some changes that were both necessary and practical. We will see if the outcome matches the expectations in the coming years.

The information provided by www.cashchronicles.com is for informational purposes only. It should not be considered legal or financial advice. You should consult with an attorney or other professional to determine what may be best for your individual needs. www.cashchronicles.com does not make any guarantee or other promise as to any results that may be obtained from using our content. No one should make any tax or investment decision without first consulting his or her own financial advisor or accountant and conducting his or her own research and due diligence. To the maximum extent permitted by law, www.cashchronicles.com disclaims any and all liability in the event any information, commentary, analysis, opinions, advice and/or recommendations prove to be inaccurate, incomplete or unreliable, or result in any investment or other losses. Content contained on or made available through the website is not intended to and does not constitute legal advice or investment advice and no attorney-client relationship is formed. Your use of the information on the website or materials linked from the Web is at your own risk.