For a number of years now, 401(k)s have served as a foundation for retirement savings in the United States. Joe Biden, the Democratic presidential nominee, has proposed some interesting changes to how the traditional 401(k) savings program works. Understanding the proposal will be important in order for you to make an informed decision at the polls at election time and to become more aware of how the changes could impact your personal tax liability. The proposal is intended to level the playing field when it comes to retirement savings. The tax breaks associated with an account such as a 401(k) disproportionately help high-earning employees. Biden has suggested replacing these tax advantages with a blanket credit or match that would be equal across all income groups.
A Closer Look at the Retirement Tax Proposal
Under the current system, employees can contribute pre-tax dollars to a retirement savings account which, in turn, reduces their taxable income. Then, when the funds are withdrawn in retirement, individuals pay income tax on them. The problem with this system is that wealthier households can afford to save more money and obtain a larger upfront tax break than those who earn less. Moreover, tax deductions in general are more valuable as people move up in tax brackets since they reduce the burden that much more. For example, someone who makes $600,000 would save $370 in taxes for contributing $1,000 to a 401(k) plan, whereas another person earning $60,000 would only reduce their tax burden by $220 for the same contribution.
Biden has proposed equalizing this incentive system by removing deductions in favor of a flat tax credit for each dollar saved toward retirement. While the campaign has not yet stated what that percentage would be, researchers from the Urban-Brookings Tax Policy Center found that a 26 percent credit would be revenue neutral for the government for at least the coming two decades. Under such a plan, both of the aforementioned parties would receive a $260 tax credit for a $1,000 contribution to a retirement account. A significant benefit of the tax credit is that it would be refundable, which means that someone who earns very little could actually reclaim some money in certain cases. Refundability provides an even greater incentive for lower earners to save for retirement.
How Critics Have Responded to the Proposal
The primary driving force behind this change is that it would equalize tax benefits. Under current tax law, about $3 trillion in tax benefits for retirement savings will be realized, although middle- and low-income earners will see very little of it. This sort of policy discourages lower earners from saving for retirement while benefiting people who are already wealthy. Critics say that it is unclear as to what extent a different policy would encourage households with lower incomes to contribute money toward retirement savings. And on the same note, the new policy could discourage individuals in higher tax brackets from using traditional retirement savings plans. Some people are calling for more research on how the change could affect behavior in order to ensure that wealthier Americans are not burdened while lower earners see gains.
Opposition to the Biden proposal has already begun to emerge. However, Democrats appear to be prepared to fight for reform, which has been a primary push by some politicians for nearly a decade.
Advocates of the Proposal Outline the Benefits
For many years, progressive politicians have pointed out that tax deductions are a sort of upside-down incentive that disproportionately benefits the wealthy, while tax credits are more accessible to virtually any American. In fact, the Tax Policy Center crunched the numbers on converting from deductions to credits in 2012. At that time, the organization estimated that instituting a 30 percent tax credit would be revenue neutral while reducing the tax burden on the bottom 90 percent of earners. Only the top 10 percent of earners would likely see an increase in their tax burden. Unfortunately, the tax code and economic conditions have both changed considerably since 2012, so making the calculations a second time will involve a lot of work.
Advocates for Biden’s proposal argue that higher earners would likely continue to save the same amount for retirement using alternative vehicles such as Roth accounts. In addition, the proposal may encourage defined benefit pension plans to regain prominence since they would retain their tax-favored status. Pension plans could, in turn, dramatically change the financial situation for lower- and middle-class households. And if financial professionals begin managing more pension plans, they could potentially have a new source of income.