A Joe Biden presidency could mean some changes to the way your retirement contributions are taxed.
The Democratic presidential candidate is proposing to equalize the tax benefits of contributing to a retirement account, so that high earners won't get a disproportionate advantage like they do now.
The status quo
Taxpayers postpone paying income tax on contributions to their traditional retirement accounts, like a 401(k). (It's the opposite for Roth IRAs, where you pay tax on the contributions but withdrawals will be tax-free.) The higher your income, the higher the value of your tax deduction.
For example, a taxpayer in the top marginal tax bracket of 37% receives a $37 tax benefit for every $100 contributed. But a taxpayer in the bottom, 10% bracket only gets a $10 tax benefit for the same contribution, according to Garrett Watson, a senior policy analyst at the Tax Foundation. So experts say those making more money have a greater incentive to contribute more to their retirement accounts.
Biden hasn't provided details, but analysts at Tax Policy Center say the change could look like replacing these tax deductions with a flat tax credit — which they estimate could be around 26% — for everyone regardless of income.
So what’s the difference between the current tax deductions and tax credits?
A deduction takes money off the top of your income, whereas a credit doesn’t lower your income but gives you a dollar-for-dollar offset for your taxes, says Bill Schwartz, certified financial planner and managing director at Wealthspire Advisors. All that income would still be taxed, but then you would get a credit after your tax was determined. Assuming the credit was 26%, if you’re contributing $10,000, it would be a credit of $2,600.
Tax credits can be either refundable or non-refundable. With a non-refundable credit, you can only benefit if you pay the full amount in taxes — so if you owe $3,000 in taxes but have a credit for $4,000, you don't receive that $1,000 difference. If a credit is refundable, you can pocket the extra $1,000.
Is this actually a way to redistribute wealth?
“Absolutely,” Schwartz says. "It further reduces taxation at lower income levels while raising taxation at higher income levels."
Here’s what this could look like.
Currently, someone single earning $40,000 a year would be in the 12% tax bracket. If they contribute $4,000 a year to their 401(k) — 10% of their income — their immediate tax savings would be $480.
Under analysts' understanding of what Biden's proposal could look like, a 26% credit would be assessed on the contribution, so the tax credit is $1,040.
That’s a net tax savings of $560 compared to the current law.
For someone single, earning $200,000 and in the 32% tax bracket, the situation would look different. If they contribute $20,000 — also 10% of their income — their immediate tax savings would be $6,400 under current law.
Under analysts' understanding of what Biden's proposal could look like, the $20,000 with a credit of 26% saves $5,200.
They would save $1,200 less than under current law.
The automatic enrollments
Alicia Munnell, director of the Center for Retirement Research at Boston College, says the tax credit would have a slightly positive effect in that it would encourage low-income people to participate and receive the equivalent of a larger match on their contribution — but it’s a modest proposal.
“This is not cosmic,” she says. What would make a big difference is making sure every worker is automatically enrolled in a retirement plan at their place of employment with the option to opt out if they want to, she says. And Biden is also considering this approach.
The presidential candidate’s plan also aims to get those who aren’t already contributing to a retirement savings account to do so. “Almost all workers without a pension or 401(k)-type plan will have access to an ‘automatic 401(k),’ which provides the opportunity to easily save for retirement at work,” his plan says.
Biden’s plan doesn’t lay out exactly what this would look like, but Munnell says we can look at auto-IRA programs at the state level to get an idea. The OregonSaves program, which began in Oregon in 2017, requires all employers who don’t offer their own employer-sponsored retirement savings plan to facilitate the auto-IRA plan. CalSavers in California requires the same for those with five or more employees.