I understand why Social Security is capped. Your monthly payment is determined as a factor of what you have contributed. If you live longer than the actuarial averages - the money you receive over and above what you have paid in over your lifetime is a net loss for the system. Thus to tax all of the earnings of a multi-millionaire means that the government would have to pay this person back at this higher rate. (Note: That is unless they choose to screw the person and cap the payouts. A very likely occurrence).
With the 401K program this point makes no sense. The only reason for the cap must be due to tax issues. If the government allows too much money to be shoveled away as pre-tax funds - this is a grand loophole for people to receive tax benefits in the long run and thus net losses of revenue. Clearly this cap is for the benefit of the government, not the individual retirement planner.
You've probably heard it over and over again: contribute up to the maximum amount in your 401(k) plan to improve your chances of a comfortable retirement.
That's the advice of many financial experts, who say it's the best way to get back the money the stock market collapse drained from your account.
However, the maximum contribution is established by using a formula tied to the third quarter Consumer Price Index for all urban consumers. That's normally not a concern for investors because inflation has steadily increased. What's potentially troubling is that the CPI-U figure for this year, to be released on Oct. 15, is expected to be lower than a year earlier.
The CPI-U measures the average change in the prices of goods and services including food, clothing, shelter, fuel, drugs and other day-to-day items bought by U.S. urban consumers. It is released by the U.S. Department of Labor.
The CPI-U jumped more than 5 percent in the third quarter of 2008 compared with the same period a year earlier, which bumped up the contribution limit for this year. But, since March 2009 the index has come in below the corresponding 2008 value. It's anticipated that this year's third quarter will be lower than the 2008 figure. That means for the first time ever, the Internal Revenue Service is faced with the likelihood that the maximum contribution level — now at $16,500 — will be lower than the year before. If current assumptions are correct, the CPI-U number will lower the amount you can contribute to your 401(k) in 2010 to $16,000.
That's not a huge problem, really, because only about 10 percent of workers contributing to a 401(k) pay in the maximum allowed.
The issue is that a lower contribution level is contradictory to the "save more, not less" message the industry has been telling people since last year's economic collapse.
"I would say that it definitely sends the wrong message at time when people are trying to recover from what's happened in the financial markets in the last 12 months," said Luke Vandermillen, vice president of retirement and investor services at Principal Financial Group Inc., a leading 401(k) provider.
About $2.7 trillion was lost in 401(k) and individual retirement accounts between September 2007 and May of 2009, says the Urban Institute, a Washington-based independent research group.
Investment advisers say the best way to regain some of that lost value is to continue to contribute and keep money in the stock market to take advantage of gains that are bound to come with economic recovery. Historically, the S&P 500 returns about 9.7 percent annually.
"At the same time we're telling people that it's critical that they're saving for retirement, and it's critical over the course of their careers that they incrementally increase their savings, if that limit goes down, it's somehow sending a message that it's OK to cut back," said Lisa Alkon, a retirement practice principal at business consultant Towers Perrin.
Since it's never happened before, it's unclear how the IRS will react if the CPI-U figures result in lowering the contribution limit, said Bill McClain, a senior consultant for human resources and business adviser Mercer LLC.
"It's a gray area and we don't know how the IRS will respond," he said. "Since we've never been in the position before where the formula has resulted in a lower limit."
The IRS released only a brief written statement that said it is aware of the issue.
"We are reviewing the relevant law," spokesman Robert Marvin said.
The law, part of the Internal Revenue Code, specifies that the retirement contribution limits are regulated by a cost of living adjustment tied to the CPI-U.
Some consultants believe congressional action is required to keep the limit from falling.
A spokesman for the House Committee on Education and Labor, which oversees legislation regarding retirement issues, declined to comment and a spokeswoman for the Ways and Means Committee, which handles revenue issues, did not immediately return calls seeking comment.