Some investment advisors see potential benefits to presidential candidate Joe Biden’s proposal to replace the 401(k) plan tax deduction with a tax credits.
While designed to help middle-income America, it remains unclear if the proposal will actually create any more incentives for the average American worker to stash more money into their retirement plan—if they’re lucky enough to have one, according to financial advisors.
The Biden proposal restructures the 401(k) contribution incentive by replacing the deduction with a tax credit, which is estimated to be 26%. Presumably, the tax credit would be refundable so that even workers with no tax liability would benefit from putting $1,000 into a 401(k) plan. As under current law with non-Roth plans, earnings would continue to accrue tax-free, and withdrawals at retirement would continue to be taxed as regular income.
The proposal, which Biden has yet to flesh out, may actually have more negatives than positives, said Robert Friedman, founder of Central Park Financial Planning in New York City.
“For middle-income people, the incentives would stay about the same since the tax credit rate of 26% is about what their marginal tax rate likely is already,” he said, adding that the tax credit probably wouldn’t be attractive to wealthier folks who instead might opt for taxable accounts or Roth accounts “if they still exist.”
“While this would create an incentive for lower or no-income people to save, their biggest impediment to savings tends to be a lack of money rather than inadequate tax incentives,” Friedman continued. “The exceptions tend to be children of well-off people, which I don't think is a target of Biden's proposal.”
Under current law, workers contribute pretax dollars and thereby reduce their annual taxable income, but they pay full tax freight when funds are eventually withdrawn in retirement. The upfront tax break is larger for richer households, however, since deductions are more valuable the higher one’s tax bracket is.
For example, take a single filer in the top 37% bracket making $600,000. For each $1,000 she contributes to a 401(k) plan, her tax deduction is worth $370. A single filer earning $60,000, however, would be in the 22% bracket and only receive a $220 tax break for that same $1,000 contribution.
What’s more, upper-income earners tend to save more in 401(k) plans, which have an annual cap that rises with inflation. In 2020, the limit is $19,500, with an extra “catch-up” contribution of $6,500 allowed for those 50 or older. The more pretax dollars set aside, the larger the tax break is.
Workers can also save $6,000 in 2020 in traditional individual retirement accounts, or $7,000 for those 50 or older. Such contributions are fully deductible unless one or both spouses also have a workplace retirement plan, in which case the deduction phases out for higher earners.