We are now (more or less) down to two main Presidential candidates: former Secretary of State Hillary Clinton and Mr. Donald Trump (hereafter, “Clinton” and “Trump”). In this article we discuss the tax proposals of each candidate and how they would affect retirement savings policy.
We begin with a discussion of the current tax system and the value (under that system) of retirement savings tax benefits.
The current system
Below are the income and capital gains/dividend tax rates applicable under the current system to joint filers in 2016 (throughout this article, when we discuss tax rates, we will only give the rates for joint filers).
|Taxable Income||Marginal Tax Rate||Capital Gains/Dividends|
|$0 – $18,550||10%||0%|
|$18,551 – $75,300||15%||0%|
|$75,301 – $151,900||25%||15%|
|$151,901 – $231,450||28%||15%|
|$231,451 – $413,350||33%||15%|
|$413,351 – $466,950||35%||15%|
In addition there is a 3.8% Medicare net investment income tax applicable to joint filers with adjusted gross income over $250,000.
Retirement savings tax benefits
Generalizing: under the current system, (non-Roth) contributions to a tax qualified retirement plan are excluded from taxable income; earnings accumulate tax free; and contributions plus earnings are taxed at ordinary income tax rates when distributed.
There are two direct tax benefits this system of taxation provides. First, assuming the participant’s tax rate is the same at the time of contribution and distribution, the value of the retirement savings tax benefit is the value of the non-taxation of trust earnings. This point must be emphasized: the value of the 401(k) tax benefit is not the value of the tax exclusion, it’s the value of the exemption from taxation of trust earnings.
Second, where the participant’s tax rate is higher at the time of (a non-Roth) contribution than it is at the time of distribution, the value of the retirement savings tax benefit is also the difference between those two tax rates. This works both ways. If you are paying higher taxes in the year of contribution than in the year of distribution, then a non-Roth contribution shifts income from a higher tax rate year to a lower tax rate year. If you are paying lower taxes in the year of contribution than in the year of distribution, then a Roth contribution does the same thing.
We cover this topic in greater detail in our article how much does my 401(k) plan save me in taxes?
Changes to the current system that affect the value of retirement savings tax benefits
Following this analysis, three sorts of changes being proposed by the current Presidential candidates will have an effect on the retirement savings tax benefits provided by the current system:
Reductions/increases in the tax on investment earnings will reduce/increase the relative value of the non-taxation of trust earnings.
Reductions/increases in marginal tax rates, and, especially, reductions/increases in the progressivity of the current income tax system, will reduce/increase the value of being able to shift income from a high tax year to a low tax year.
Proposals to “cap” the value of deductions/exclusions will reduce retirement savings tax benefits for those affected by the cap.
A couple of preliminary remarks: First, these are just proposals. Trump has already made comments that could be understood as indicating a willingness to change his position on tax policy. And there are numerous questions about both candidates’ proposals. Second, no matter how committed to a particular tax policy, whoever is elected President will still have to reckon with Congress, and there are senior members of both parties, in both houses, who have their own tax policy commitments.
So what follows must be taken as tentative. It is best understood as an outline of each candidate’s tax policy concerns and biases (using that term in its non-pejorative sense), rather than as a description of how the Tax Code will actually change if one or another candidate is elected.
Given that background, we are going to discuss these proposals thematically, rather than go into them in deep and technical detail on them.
Capital gain and dividend tax rates
Clinton would increase capital gains/dividend taxes on individuals making more than $5 million a year from 20% to 24%. Perhaps more significantly, however, she would increase the capital gains holding period requirements for taxpayers making more than $465,000 a year:
[A]s president, I would move to a six-year sliding scale that provides real incentives for long-term investments. For taxpayers in the top bracket – families earning more than $465,000 a year – any gains from selling stock in the first two years would be taxed just like ordinary income. Then the rate would decrease each year until it returns to the current rate.
Thus, unless a high-income taxpayer holds an investment for a full six years, the capital gains tax rate would, under Clinton’s proposal, go up significantly. If an asset were sold in the first two years, the tax on any gain for a taxpayer making, say, $500,000 could be as high as 43.4% – 39.6% plus the 3.8% Medicare net investment income tax.
Trump would eliminate capital gains/dividend taxes for joint filers making more than $75,300 and less than $100,001 – they are taxed under current rules at a 15% rate. He would increase the capital gains/dividend tax rate for persons making more than $300,000 and less than $466,951 from 15% (currently) to 20%. While Trump has said that he would repeal the Affordable Care Act, it’s not clear that he would repeal the 3.8% Medicare net investment income tax.
Generally, these changes, because they (in most cases) increase the taxes on saving outside a plan, will make qualified plan retirement savings more attractive. For instance, if Clinton’s holding period rules were enacted, investors valuing the ability to sell investments over a shorter period would have a significant tax incentive to make that investment inside a qualified plan.
Income tax rates
Clinton would impose a 4% surcharge on incomes over $5 million and impose the “Buffett rule” (ensuring “that those making more than $1 million per year pay at least an effective tax rate of 30 percent”), but she would not otherwise change income tax rates.
Trump would generally cut income taxes across the board, proposing new marginal income tax rates as follows:
|Taxable Income||Marginal Tax Rate|
|$0 – $50,000||0%|
|$50,001 – $100,000||10%|
|$100,001 – $300,000||20%|
Generally, we would not expect Clinton’s (limited) changes to current rules to have a significant effect on retirement savings. The one exception: individuals at or near the $1 million threshold for application of the Buffett rule may have an incentive to increase qualified retirement savings to avoid application of that rule.
It’s harder to evaluate the effect of Trump’s proposals. As we said, with respect to income shifting, it’s not tax rates that matter so much as progressivity. Will, for instance, the fact that his tax rate doubles (from 10% to 20%) on income over $100,000 provide an incentive for significant income shifting via retirement savings? Perhaps.
Cap on deductions/exclusions
Clinton would impose a “deduction cap.” This proposal, more or less adopted from the proposal in recent Obama Administration budgets, would limit the value of itemized deductions of taxpayers in higher brackets to 28%.
Trump also proposes to cap deductions:
With this huge reduction in rates, many of the current exemptions and deductions will become unnecessary or redundant. Those within the 10% bracket will keep all or most of their current deductions. Those within the 20% bracket will keep more than half of their current deductions. Those within the 25% bracket will keep fewer deductions.
Trump does not specify how the reduction in “current deductions” would work or whether it would affect, e.g., 401(k) contributions.
It’s unclear, at this point, whether either of these caps would apply to qualified plan retirement savings. The current Obama Administration proposal for a 28% deduction cap does apply to “employee contributions to defined contribution retirement plans and IRAs.” It further provides that “[i]f a deduction or exclusion for contributions to retirement plans or IRAs is limited by this proposal, then the taxpayer’s basis will be adjusted to reflect the additional tax imposed.” For a taxpayer at the current top tax rate (39.6%), a 28% cap on, e.g., the income exclusion for 401(k) contributions reduces the 401(k) tax benefit by around half.
The idea of applying a deduction/exclusion cap to DC plans is still very much a work in progress. For starters, no one has suggested that a similar cap be applied to DB plans, and indeed it’s hard to conceive how such a cap for DB plans would work. But if a similar cap is not applied to DB plans, the most likely result would be that many tax-motivated retirement savers would simply shift savings to, e.g., cash balance plans.
That said, this proposal probably is the most serious threat to the DC retirement savings tax benefit.
Is fundamental tax reform, of the sort both Clinton and Trump are proposing, likely in the near future – whoever wins?
Maybe – but it is probably still a long shot. There is bipartisan support in Congress for doing something about the corporate tax. And if either Clinton wins and Democrats take back the House and the Senate, or Trump wins and Republicans hold onto both the House and the Senate, then a purely partisan revision of the Tax Code along the lines outlined above is possible.
We will continue to follow this issue.