Policymakers have had little luck in reforming the tax structure for 401(k) defined contribution plans (as well as their siblings 403(b) and 457 plans) for decades. It’s been easy to add benefits—new ways to save such as the SIMPLE IRA, higher contribution limits, and a “Roth” option to use post-tax money that can grow and be withdrawn tax-free—but no one has had much luck reforming the basics of the system. Biden is going to try if he wins the upcoming presidential election, and that has important implications for retirement savers.
For a quick review, at least for the retirement plan participant, the tax benefits for saving in a traditional 401(k) or other tax-privileged retirement plan are inversely related to income. That is because these contributions reduce a wage-earner’s taxable income, and the United States has a progressive tax system. Under a progressive tax system, tax rates increase as workers earn more money. The highest tax rate a person pays is called their “marginal rate.” Since higher-income people have higher marginal tax rates, they benefit the most when they reduce their taxable income by contributing to a retirement plan.
Biden’s plan has few details, but the most important one is clear: He would “equalize the benefit across the income scale so working families also receive a substantial tax benefit when they put money away for retirement.” This would probably lead to about a 26% credit on every dollar any worker saved for retirement. (That estimate assumes Biden’s plan would not change the total amount of the tax incentive to save in a retirement plan, just the way the tax benefit is distributed.)
The proposed changes would increase the benefits of saving for retirement for some and reduce it for others. Individual earners making less than $163,300 currently pay a marginal tax rate of 24%, so these workers would see at least a small benefit. Some workers—for example, those earning less than $40,126—could see their tax benefit from contributions to 401(k) more than double. Married workers earning a total of less than 326,601 would similarly see a small increase in their tax benefit from contributing to a retirement plan.
One gut reaction to this proposal might be to predict that Roth contributions will become more popular among high earners if Biden wins the election and is able to implement this plan. After all, if they are going to get less of a break on the contribution, high-income people may reason, why not contribute after-tax money and avoid taxes in the future.
That may well be true to some extent, but these higher-earning people would also have to assume that their effective tax rate in retirement would be less than 26% to make this worthwhile. Unlike the marginal tax rate, which is the highest rate a taxpayer pays, the effective tax rate is the weighted average of the various rates of taxes one pays on all their income in a given year. No one knows what the future holds for tax rates, but a 26% benefit today would still be attractive.
There is another good reason this policy might not make Roth contributions attractive, depending on unreleased details. The plan appears to be based on a proposal from 2012. (Incidentally, this proposal has authors from the conservative Heritage Foundation and more center-left Brookings Institution.) If it hewed to that proposal, it would automatically direct the tax benefits into a retirement account rather than simply reduce a worker’s taxes. This is a really good idea because it makes the tax break effectively a government match.
Such a “government match” provision also could mean that contributing the maximum to a traditional 401(k) account would be more attractive than using a Roth vehicle. Contributing the maximum to a traditional account would still result in a 26% additional match from the government. Of course, one could argue that maxing out the Roth contributions is economically equivalent to depending on future tax rates because the money will be taken out tax-free, but human psychology means most of us would rather see a larger account balance than a smaller one.
Finally, there is an open question as to whether the new approach would include a refundable tax credit. Again, Biden’s policy position states that his plan would “equalize the benefit across the income scale so working families also receive a substantial tax benefit when they put money away for retirement.” If that’s literally true, then millions of Americans with small or no tax liabilities would still get the government match. To make that policy revenue-neutral, the tax credit would need to be smaller than 26%, reducing retirement benefits for more people.
While Biden’s proposal is light on details, the major piece is clear. It would seek to add more fairness to the system and would reduce the marginal benefits for high-income people. Nonetheless, those that could afford to contribute the most would still get more total tax benefits than those that could not. Still, advisors and investors should monitor this proposal because it might make Roth accounts more attractive under some circumstances.