Spring 2021 Fiduciary Commentary
Change is in the air. As the newly elected president who won a decisive victory against a polarizing incumbent, one would expect the Biden administration to feel as if there was a calling from above for change. In his first 100 days as president, Joe Biden has proposed a litany of spending proposals. After signing the $1.9 trillion American Rescue Plan into law, Biden has proposed two additional multi-trillion-dollar spending proposals: the $2.65 trillion American Jobs Plan and the $1.8 trillion American Families Plan. It is nearly a forgone conclusion that these new initiatives will be at least partially funded by tax increases on high-earners and businesses.
Although not a prominent focus on the campaign trail, retirement policy appears to be on the new administration’s focus list. Among the multiple retirement policy proposals that we may see from the White House are small-business tax credits for new plans, mandatory automatic enrollment, and changes to the fiduciary rule. By far the most impactful proposal is an overhaul of the current retirement savings tax breaks that many in the ruling party see as disproportionately benefiting higher earners. This is not because savers with higher incomes have more money to put aside in their retirement plan, but how retirement plans inherently work involving taxes.
When an employee contributes to their retirement plan by making a traditional pre-tax contribution, the saver receives a deduction for their federal (and potentially state) income taxes. Taxes are eventually paid when the savings is withdrawn, typically in retirement. (Taxes on retirement savings are inevitable. It is simply a question of how you wish to pay them – now or later.) As with income tax rates, the amount of the tax deduction depends on the investor’s income. The higher an investor’s income and marginal tax rate, the more beneficial the tax deduction.
By way of example, a single saver with annual taxable income of $150,000 would land in the 24% income tax bracket. Under current law, if they make a traditional pre-tax plan contribution of 10% of their income, they would receive a $3,600 federal income tax reduction. Someone in a lower tax bracket would receive a smaller benefit. A saver earning $40,000 per year would place in the 12% tax bracket and produce a $480 federal income tax reduction with a 10% pre-tax deferral. The administration is taking the position that the current system does not provide an adequate incentive for lower income workers to utilize retirement accounts in comparison to the incentive for higher income earners.
Now Credits Not Deductions
President Biden’s retirement policy proposal calls for changes to this tax treatment of participant contributions made to employer sponsored retirement plans. The proposal’s intention is to make the benefits of retirement plan contributions more equitable across income levels. In seeking to level the disparity of benefits between low and middle-income employees with those in higher income brackets, Biden’s plan proposes a flat 26% tax credit for retirement plan contributions that would replace the current regime of tax deductions. The credit would also be refundable, so savers earning too little for the credit to offset their income tax liability would still receive the full benefit of the credit. Currently, it is unclear what impact, if any, such a change would have on the deduction for employer contributions to qualified retirement plans.
Biden’s proposal would completely transform the current retirement system. Under the initiative, an earner in the top income-tax bracket would essentially receive the same tax break as an earner in a lower-income tax bracket. While the resulting credit would be less than the deduction for people in higher income brackets, it could significantly impact savers with lower salaries to promote additional savings.
The Potential Consequences
While the policy to encourage savings with a refundable tax credit is admirable, there are always consequences to any change of this magnitude. A projected shift in retirement plan tax benefits from a deduction to a credit could have significant implications for high-income savers. Traditional pre-tax contributions to employer plans will become less advantageous for this economic class and may affect their savings habits.
Assume a high-earning individual in the 32% income tax bracket made the maximum deferral contribution to their 401(k) of $19,500, they would receive a tax credit of $5,070 (26% of $19,500) and effectively pay $1,170 more in tax ($6,240-$5,070) than in the current system. While still a potentially attractive tax benefit, the reduction in tax savings may push many high earners to evaluate Roth savings in their plan as an attractive alternative. Savers in the 26% tax bracket and above may determine that a plan Roth contribution may be more desirable due to their tax-free growth and distributions and no requirement for required minimum distributions at 70½ (from Roth IRAs). This may be even more appealing for employees approaching retirement if they perceive income tax rates to be higher in retirement.
Furthermore, small-business owners may have less motivation to maintain a retirement plan for their business if the tax incentives for them are diminished. They may find more attractive personal savings vehicles like Roth IRA accounts, rather than sponsoring an expensive and burdensome qualified plan.
Roth conversions may gain in attractiveness as well, especially if there is a reduction in the estate tax exemption. Individuals with a sizable net worth can use a Roth conversion to strategically reduce the size of their taxable estate and potentially reduce or avoid federal estate tax. Of course, Roth conversions come with their own issues. Primarily, the necessity to pay the tax liability associated with the conversion. Additionally, a Roth conversion would likely raise the taxpayer’s income and potentially put them in a higher tax bracket.
Biden’s policy goal is admirable – relieving some barriers to saving, barriers that are more prevalent for certain lower-income families, could go a long way to encourage additional savings for those that need it most. The administration’s proposal though would be a significant revision in how employer plans work creating real implications for savers in every tax bracket. For a fundamental change such as this, more research and analysis should be done on the impact this would have on retirement savings amongst savers of all salary levels.