Repeal of Affordable Care Act: effect on retirement savings

March 13, 2017

One of the more controversial elements of the proposal to “repeal and replace” the Affordable Care Act (ACA), introduced by House Republicans March 6, 2017, is the repeal of the ACA 3.8% Medicare Net Investment Income (NII) tax.

In this article we briefly discuss how that change, if enacted, would, for certain high-earners, reduce the relative value of saving in a 401(k) plan vs. saving outside the plan. We begin with a discussion of how the NII tax currently works and how it affects the (relative) value of 401(k) plan savings and then discuss how its repeal would reduce the value of those savings. (While, in this article, we illustrate tax effects with respect to 401(k) plans, the analysis provided applies to all tax-qualified plans.)

Medicare Net Investment Income tax and the relative value of 401(k) plan savings

As we have discussed (see our article A note on the retirement savings tax benefit), assuming an individual’s tax rate is the same at the time of contribution and distribution, the tax benefit provided by saving in a tax qualified plan (e.g., in a 401(k) plan) is, and is only, the tax-exempt trust earnings. That benefit is, therefore, equal to the tax that would otherwise be paid on investment earnings outside the plan. (Where the tax rate at the time of contribution and distribution is different, there is also the possibility of a tax benefit from shifting income to a lower tax rate year.)

Currently, the tax on investment earnings (capital gains and dividends, but not interest) depends on the individual’s tax bracket: taxpayers in the 10% and 15% brackets pay no capital gains/dividends taxes; taxpayers in the 25%-35% brackets pay at a 15% rate; and taxpayers in the 39.6% bracket pay at a 20% rate.

For certain taxpayers (e.g., joint filers with adjusted gross income over $250,000), the 3.8% Medicare NII tax is added to capital gains and dividend taxes. So, e.g., taxpayers in the 39.6% tax bracket generally pay a 23.8% tax (20% capital gains and dividends taxes and 3.8% Medicare NII tax) on investment income.

Current value of 401(k) plan savings for a high earner

With that background, let’s consider the value of saving in a 401(k) plan vs. saving outside the plan, for an individual in the highest tax bracket who is also subject to the Medicare NII tax.

The following table shows the tax savings resulting from saving $18,000 (the maximum elective deferral for 2017) inside a 401(k) plan vs. saving the same amount outside a 401(k) plan, based on the given assumptions.

Assumptions
Contribution $18,000
Earnings rate 3%
Years in plan 10
Income tax rate at contribution 39.6%
Capital gains and dividend tax rate 20%
Income tax rate at distribution 39.6%
Medicare NII rate 3.8%
Value of in-plan savings $982

The additional value here – the $982 more that a 401(k) plan saver will have after her benefit is distributed than if she had saved outside a plan – results entirely from the investment tax exemption 401(k) plan savings enjoys. For this taxpayer, those taxes are at the highest rate – 23.8%.

Effect of repeal of Medicare NII tax on the value of 401(k) plan savings for a high earner

The repeal of the Medicare NII tax will reduce the investment taxes this individual is paying and will therefore reduce the relative value of saving in a qualified plan.

The following table compares current tax savings to tax savings after the repeal of the Medicare NII tax.

Assumptions
Contribution $18,000
Earnings rate 3%
Years in plan 10
Current
Repeal and
Replace
Income tax rate at contribution 39.6% 39.6%
Capital gains and dividend tax rate 20% 20%
Income tax rate at distribution 39.6% 39.6%
Medicare NII rate 3.8% 0%
Value of in-plan savings $982 $829

Thus, the repeal of the Medicare NII tax reduces the relative value of in-plan savings by (on these assumptions) $153 or around 15%.

* * *

None of the foregoing is to say that repeal of the Medicare NII tax is either a good or bad idea: views on that will depend on political commitments with respect to a number of issues totally unrelated to retirement savings. Nor does it mean that repeal of this tax is “bad” for retirement savings. Our only point is that, if this tax is repealed, at the margin, the relative value of retirement savings will go down – in our illustration, by around 15% – for certain taxpayers.

We will continue to follow this issue.

October Three Consulting, LLC is a full service actuarial, consulting and technology firm that is a leading force behind the reemergence of defined benefit plans across the country. A primary focus of the consultants at October Three is the design and administration of comprehensive retirement benefits to employees that minimize the financial risks and volatility concerns employers face.

Through effective plan design strategies October Three believes successful financial outcomes are achievable for employers and employees alike. A critical element of those strategies is the ReDB® plan design. The ReDefined Benefit Plan® represents an entirely new, design-based approach to retirement and to the management of both the employer’s and the employee’s financial risk, focusing on maximizing financial efficiency and employee value.

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