As the November election draws near, some attention has been focused on a particularly contentious plan by Joe Biden to eliminate the 401(k) deduction. In truth, Biden isn’t proposing to eliminate the 401(k) deduction as much as to replace it with a tax credit.
Be that as it may, defined contribution retirement plans have become nearly sacred in America’s financial heart. Any major proposal that threatens to change how that system works will be unsettling, to say the least.
The Substance of the Biden 401(k) Proposal
Unfortunately, details on the Biden retirement plan proposal are scarce. In fact, the proposal itself is surprisingly vague. The basic concept is explained, but no numbers are provided. Instead, analysts and commentators are drawing from numbers that have been published in the past or from independent sources.
According to The Biden Plan for Older Americans, which addresses multiple issues related to the elderly, the proposal for a change in the tax treatment of retirement contributions says only this:
“Equalizing the tax benefits of defined contribution plans. The current tax benefits for retirement savings are based on the concept of deferral, whereby savers get to exclude their retirement contributions from tax, see their savings grow tax free, and then pay taxes when they withdraw money from their account. This system provides upper-income families with a much stronger tax break for saving and a limited benefit for middle class and other workers with lower earnings. The Biden plan will equalize benefits across the income scale, so that low- and middle-income workers will also get a tax break when they put money away for retirement.”
Probably the closest we have to a hard number – if that’s even what it is – is a tax credit of 26% of the amount contributed to a retirement plan. That, at least, is the number that’s been reported by the independent Tax Foundation, and widely quoted in other sources. In theory at least, a 26% credit would be revenue neutral. It wouldn’t cost the government in lost tax revenue, but it would equal out the tax benefit received by both upper income and lower income taxpayers.
That’s the theory, at any rate.
Biden’s 401(k) Plan is Not Without Merit
Admittedly, the initial reaction of millions of Americans to the possibility of losing the hallowed retirement plan contribution tax deduction is unsettling, to say the least. Given that the Tax Cuts and Jobs Act of 2017 enacted under the Trump Administration reduced or eliminated many common deductions – largely by dramatically increasing the standard deduction and capping mortgage interest deductions and state and local taxes – the tax deductibility of retirement contributions is one of the few tax shelters remaining, particularly to the middle class.
But the basic intent of Biden’s proposal is to share the wealth when it comes to the tax benefits of making retirement plan contributions.
Under current tax law, a person in the 12% marginal federal tax bracket will receive a $720 tax break on a $6,000 contribution to a traditional IRA. But for the taxpayer in the 37% marginal bracket, the benefit will be $2,220. That’s more than three times the benefit to the lower income tax filer.
Under the Biden proposal, and assuming an across-the-board 26% tax credit on retirement plan contributions is the number it includes, both workers would get the same tax benefit – $1,560.
Though the argument that higher income taxpayers may be less likely to contribute to retirement plans with a lower tax benefit, there’s little doubt such a proposal would increase the incentive for lower income workers to contribute. That would certainly provide an incentive to millions of Americans who might otherwise be primarily or even entirely dependent on Social Security for retirement income.
Six Reasons Why the Biden 401(k) Proposal Won’t Fly
Despite the merits of the Biden 401(k) proposal, any change as significant as the elimination of the tax deductibility of retirement contributions will face an uphill fight.
Here are six reasons that’s unlikely to happen:
1. Tax Deductible Retirement Contributions Have Become Part of the American Way
The advent of IRAs, 401(k)s and other defined-contribution retirement plans began back in the 1970s. That makes them more than 40 years old, which is long enough for them to have become viewed as something akin to being a part of the Bill of Rights. Many people have been invested in them for decades and will recoil at the mere suggestion of changing the way they work.
But apart from the tax benefits Americans have come to embrace with retirement plans, including tax deductibility of contributions and tax deferral of investment earnings, one very important quality about the plans is that they belong to the individual.
In a nation that’s traditionally valued rugged individualism, the notion of having control over one’s retirement assets is a powerful one. This is only underscored by the fact that defined contribution retirement plans are frequently the largest single financial asset owned by millions of Americans. A major change in the tax treatment of these plans may be seen as an assault on that individual control.
It wouldn’t be an exaggeration to say that many Americans are emotionally bonded to the idea of the current concept of defined contribution retirement plans.
2. The Shear Size of Defined Contribution Retirement Plans
As of 2020, there is approximately $32.7 trillion sitting in retirement assets in the US. Of this total, $11 trillion is in IRA accounts, $6.2 trillion in 401(k) plans, and $2.7 trillion in other defined contribution plans. That means nearly 2/3 of all retirement savings in the US are sitting in defined contribution plans that could be affected by Biden’s proposal.
Since much of this money is invested in the financial markets, any significant changes in the way the plans work could cause confusion and insecurity that could have a negative impact on those markets. Any political figure, including a future president of the United States, will face overwhelming resistance in attempting to alter a financial arrangement of that magnitude and potential impact.
3. Retirement Investment Industry Resistance
Since defined contribution retirement plans make up nearly $20 trillion, any major changes in the current format will be resisted by the retirement investment industry. There’s already evidence that such a challenge is in the works.
Though there’s little doubt that self-interest plays a major role in the opposition the retirement investment industry will have to a major change in the tax treatment of defined contribution retirement plans, there may be a bigger issue at stake.
Major changes have a way of bringing about unintended consequences. Despite the best intentions of a future Biden administration in its efforts to make the retirement contribution system more equitable, the possibility that such a change could seriously impair a system that has been working well for more than four decades can’t be easily dismissed.
Cleaning up that unintended mess could even require a costly industry bailout that won’t fit neatly within a federal government budget that’s already seriously in deficit.
4. Tax Credits May Address the Tax Benefit at the Federal Level, but Hurt Taxpayers with State Income Taxes
While it may be possible for the Biden proposal to successfully replace tax deductibility with tax credits for federal income tax purposes, the outcome may be very different for income taxes at the state level.
Many states base their resident’s taxable income on their federal adjusted gross income (AGI). As federal tax law currently stands, that income is reduced for retirement contributions. If those contributions are removed as deductions from federal AGI, more taxpayer income will be subject to taxation at the state level.
It’s a problem that may be correctable at the individual state level, but when spread across dozens of states the outcome will be more problematic. This will be especially true if states, wrestling with their own fiscal issues, take advantage of retirement contribution shifts as a form of a back door tax increase.
5. The Amount of the Tax Credit is Uncertain, and can be Reduced After the Fact
One of the reasons for the success of the tax deductibility of retirement contributions is the progressive nature of the US tax code. Under current law, there are seven different marginal tax rates, ranging from 10% on the low-end to a high of 37%. Those rates haven’t changed substantially over the years, and they provide a major incentive for individuals to contribute to tax-deferred retirement plans.
The situation can be very different tax credits. They are, after all, calculated using either a specific percentage, a dollar limit, or combination of both. Those numbers can be tweaked, and frequently are. Should the federal government encounter a fiscal crisis, retirement tax credits could easily be lowered to less generous levels. That holds the potential for dramatic shifts in the amount of money contributed to retirement plans on an annual basis.
It’s also possible that confidence in the defined contribution retirement plan system could be undermined by one or a series of changes in either the credit itself or any limitations that may be imposed on it.
But even more fundamentally, the tax credit percentage of 26% is little more than a convention at this point. The outcome could change if the credit were reduced to something less, like 20%, or even 15%. Since a lower tax credit would result in an effective tax increase, passage of the plan by Congress would be even more unlikely.
6. Biden has Many Other Battles Within His Tax Proposal
A visit to Joe Biden’s campaign website reveals a laundry list of changes and proposals that may be more extensive than any other presidential candidate in history. The site reports no fewer than 46 proposals, ranging from jobs and economic recovery for working families, racial equality, sustainable infrastructure and a clean energy future, an agenda for women, Covid-19, bankruptcy reform, immigration, campaign finance and government reform, education, ending gun violence, criminal justice reform, health care, and climate change, among many others.
As significant as a plan to replace the 401(k) deduction with a tax credit may be to millions of Americans saving for retirement, it may ultimately be a proposal a Biden administration will prove unwilling to expend significant political capital on.
“He (Biden) also wants to increase Social Security benefits, lower the Medicare eligibility age, and to raise taxes to help pay for it,” notes Forbes Staff Advisor, Taylor Tepper. “Biden will likely spend his political capital on those policies, rather than picking a bitter fight with the investment industry that’ll ultimately alienate small businesses and upper middle class voters all for a proposal that won’t make Americans retirement prospects that much more secure.”
It’s entirely possible the Biden plan to eliminate the 401(k) deduction won’t destroy retirement savings as we know it, or even materially affect the financial markets. And it may even prove to be a major benefit to middle- and lower-class wage earners.
But given all the obstacles the proposal faces, as well as the many other proposals Biden plans to advance, the likelihood of a complete overhaul to the tax treatment of retirement plan contributions is unlikely to become a reality. The fact that it is projected to be revenue neutral for the government effectively removes any incentive for Congress to act on the proposal, whether it’s controlled by the Democrats or the Republicans.
I wouldn’t waste too much time worrying about this proposal.
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