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In our first article in this series we discussed current 401(k) tax benefits. In this article we discuss how the proposals of three Republican candidates – Mr. Donald Trump and Senators Marco Rubio (R-FL) and Ted Cruz (R-TX) – would affect those benefits.
Mr. Trump’s proposal “works within the current system” – that is, he is not proposing (like Senator Rubio) to eliminate all taxes on investment or (like Senator Cruz) to implement a flat income tax and a business tax that looks something like a VAT.
Trump proposes new marginal income and investment (capital gains and dividends) rates as follows:
| Taxable Income | Marginal Tax Rate | Capital Gains and Dividends Rate |
| $0 – $50,000 | 0% | 0% |
| $50,001 – $100,000 | 10% | 0% |
| $100,001 – $300,000 | 20% | 15% |
| $300,001+ | 25% | 20% |
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 401(k) contributions. The Tax Policy Foundation interprets Trump’s proposal, generally, as capping the value of deductions at 10% – thus, a person paying taxes at the 25% rate would only be able to deduct at a 10% rate.
Let’s consider the effect of this proposal on the two explicit 401(k) tax benefits we discussed in our first article – deferral of taxation of trust earnings and income shifting.
Trump’s proposal would actually increase the tax on investment earnings (capital gains and dividends) for joint filers making $300,001-$466,950. That is, under current rules, in 2016, 20% capital gains rates apply to joint filers with taxable income above $466,950; Trump would apply 20% capital gains rates to joint filers with taxable income above $300,000. Such a change would, for those taxpayers, increase the value of 401(k) tax savings resulting from the deferral of taxation of investment earnings. On the other hand, he eliminates the investment tax for taxpayers making $100,000 or less, decreasing the value of that 401(k) tax savings for them.
Trump would lower marginal tax rates across the board. But when considering the value of the ability to shift income from a low tax year to a high tax year, what matters is not just the absolute rates of taxation but also the relative rates of taxation – the progressivity of rates. Under Trump’s proposal, the tax rate for a joint filer with, say, $175,000 in taxable income is twice as high (20%) as the rate applicable to the joint filer with $95,000 in taxable income. Being able to cut your taxes in half by shifting income from one year to another is valuable.
To illustrate this effect, let’s consider how the numbers play out for a joint filer saving $1,000 in a 401(k) plan, making $175,000 in taxable income at the time of contribution and $95,000 in taxable income at the time of distribution. Under the current system, this taxpayer would pay taxes on $1,000 at a 28% rate (based on $175,000 in taxable income at the time of contribution) – $280. Instead, she contributes the $1,000 to a 401(k) plan and pays taxes on $1,000 at a 25% rate (based on $95,000 in taxable income at the time of distribution) – $250. She saves $30 (3% of her $1,000 contribution).
Under Trump’s proposal the same taxpayer would have paid taxes on $1,000 at a 20% rate (at the time of contribution) – $200. Instead, she contributes the $1,000 to a 401(k) plan and pays taxes on $1,000 at a 10% rate (at the time of distribution) – $100. She saves $100 (10% of her $1,000 contribution).
All of this assumes that Trump’s 10% cap on deductions does not apply to the current exclusion for 401(k) contributions. If it did apply, it would effectively eliminate the ability to shift income from a higher tax rate year to a lower tax rate year.
Thus, under Trump’s proposal, 401(k) contributions would in many cases have increased “tax appeal”: for savers in the $300,001-$466,950 income range and, if his deduction cap does not apply to the 401(k) exclusion, to persons for whom the ability to shift taxable income from one year to another is valuable.
Senator Rubio would change the current tax system more fundamentally.
Rubio would provide for only two tax rates. Here are the rates for joint filers:
| Taxable Income | Marginal Rate |
| $0-$150,000 | 15% |
| $150,000+ | 35% |
We note that this proposal would increase the income tax rate to 35% for joint filers currently paying tax at a 28% rate (incomes from $151,901 – $231,450) and 33% (incomes from $231,451 – $413,350).
More significantly, however, Rubio would eliminate taxes on investment (capital gains and dividends). Under Rubio’s proposal:
C corporations would pay a 25 percent corporate tax. Since the businesses’ income would be taxed at the entity level, dividends and capital gains on stock would not be subject to additional tax at the individual level. [Emphasis added.]
While short on specifics, Rubio’s plan would, as we understand it, allow 401(k) plans to continue.
Rubio’s proposal to eliminate taxes on investment earnings would eliminate the first 401(k) tax benefit – the deferral of tax on trust earnings. Under the Rubio proposal, corporate earnings are taxed entirely at the corporate level. Returns net of the corporate tax would be distributed (as dividends) or realized (as capital gains) by shareholders tax-free. Thus, there would be no tax benefit to holding shares in a 401(k) plan vs. a simple brokerage account.
On the other hand, the cliff between Rubio’s lower 15% tax rate and his higher 35% tax rate is so great – the higher rate is more than twice the lower rate – that the ability to shift income from a high-rate tax year to a low-rate tax year would be very valuable.
Thus, under Rubio’s proposal, 401(k) plans would still have significant “tax appeal” – but only for taxpayers for whom the ability to shift income from a high-rate tax year to a low-rate tax year is meaningful – individuals with, as it were, lumpy income. We would observe, however, that many policymakers might question the validity of a tax provision if its only function is to shift income from a higher-rate tax year to a lower-rate tax year.
Senator Cruz would substitute, for the current system, a 10% flat tax on income and a 16% “Business Transfer Tax.” According to Cruz: “This tax is levied on all business profits, less capital investment. This would include the payroll of business, government, and non-profit institutions, as well as net imports. The tax would exempt from taxation the purchase of health insurance.” Note that the 16% business-level tax would apply to payroll, with an exclusion for health insurance but not for retirement savings.
According to the Tax Foundation, the Cruz proposal also “Preserves the exclusions from income of pension contributions ….” In that regard, Senator Cruz would create a new “Universal Savings Account” (USA). Via the USA, taxpayers could save up to $25,000 annually on a “tax-deferred basis.”
It appears (although it is not entirely clear) that Senator Cruz would eliminate Tax Code section 401(k) and substitute for it the $25,000 a year USA contribution. According to Cruz, USA savings could “be used for any purpose, allowing families to save and build for their future.” This looks a lot like the Lifetime Savings Accounts proposed by President George W. Bush. It would (apparently) undercut our current employer-mediated 401(k) system: you would (apparently) not have to have an employer-provided plan to take advantage of the USA savings tax deferral. And it would not limit the tax incentive for savings to retirement savings.
Let’s consider the value of the USA as an alternative to current 401(k) savings in the context of Cruz’s broader tax proposal, focusing on the two tax benefits we have identified: deferral of taxation on trust earnings and income shifting.
Cruz would reduce the tax on capital gains and dividends to 10% – the same as the tax on income. This would reduce but not eliminate the value of the non-taxation of trust earnings. On the other hand, a flat tax on income would eliminate any benefit from income shifting.
Thus, under the Cruz proposal, the “tax appeal” of retirement savings would be reduced. But, in the tax system envisioned by Cruz, there would be very few tax breaks. That is, obviously, the tradeoff for such a low, flat tax rate. And the USA savings tax break would be one of the few left.
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We want to emphasize that our treatment of the candidates’ proposals has been thematic – that is, we are focusing on how certain types of tax changes would affect 401(k) “tax appeal.” Thus, e.g., a key point about Cruz’s proposal is that a single flat personal income tax would eliminate the value of income shifting, and a key point about Rubio’s proposal is that eliminating investment taxes would eliminate the value of the deferral of taxation of 401(k) earnings.
As we said, after the nominating conventions, when we get down to two candidates, we will discuss with more detail and specificity their tax and retirement policy proposals.
Our next article in this series will consider Democratic proposals.