Retirement savings tax incentives and 2021 tax legislation

October 1, 2021, begins a new federal fiscal year. Congressional Democrats will then have another shot at passing budget reconciliation legislation requiring only a simple majority in the Senate (50 Democrats plus the Vice President sitting as President of the Senate). They are likely, at that time, to take up tax legislation that will have both direct and indirect effects on retirement savings policy.

In what follows, we review the retirement savings tax incentive basics of the current system and how Democrat-proposed changes in basic tax policy, e.g., increases in income and capital gains taxes, might affect them. We also consider some proposals that may directly affect retirement policy and briefly note some non-tax retirement policy initiatives that might be included in the budget package.

(In this article we generally focus on the defined contribution plan tax incentive calculus, because the math is more straightforward, but the same principles will apply to defined benefit plans.)

The current system

Below are the income and capital gains/dividend tax rates applicable under the current system to joint filers in 2021 (throughout this article, when we discuss tax rates, we will only give the rates for joint filers).

Table 1: Income tax rates (joint filers)

Table 2: Capital gains/dividend tax rates (joint filers)

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.

This system of taxation provides two direct tax benefits to participants saving in traditional 401(k) plans: 

(1) 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 this tax benefit is not the value of the tax exclusion, it’s the value of the exemption from taxation of trust earnings.

(2) Where the participant’s tax rate is higher at the time of (a non-Roth) contribution than it is at the time of distribution, there is a second retirement savings tax benefit equal to 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.

Effect of possible increase in income and investment taxes

Democrats are considering increases, for high paid individuals, in both income and investment taxes. With respect to tax benefit (1), these increases will (on balance) increase, in some cases significantly, the value (to affected high paid individuals) of saving inside a tax qualified retirement plan, generally because the taxes on non-plan saving would have been increased.

The increase in income taxes may also increase the value of tax benefit (2), although this will depend less on the rate increases themselves and more on the steepness of the progressivity of the new rates. For instance: being able to shift income from (in the year of contribution) a tax rate of 37% (the current top rate) to (in the year of distribution) the next lower rate of 35% is less valuable than being able to shift income from, say, a 39.6% rate to a 36% rate.

Roth vs. non-Roth treatment

One feature of SECURE 2.0 legislation currently being considered by the House of Representatives is a proposal to limit 401(k) catch-up contributions to “Roth-only.” Probably the greatest effect this sort of proposal would be to limit the ability of high income/high tax bracket employees to (through catch-up contributions) shift income to a lower tax year.

In the 2017 Trump tax reform effort, Republicans considered a broader version of this sort of “Rothification,” as a revenue-raiser, but ultimately dropped it as politically unpopular.

Cutting tax benefits for the “high paid”

Democrats have (in the past) made several proposals to cut back retirement savings tax benefits for the “high paid.” These include:

Capping the exclusion. The Obama Administration proposed capping the exclusion at 28% – thus, for instance, a taxpayer in the (then applicable) 39.6% bracket would pay an 11.6% tax on a regular 401(k) contribution.

Capping the total benefit. The Obama Administration also proposed capping the total benefit a taxpayer could accumulate in IRAs and defined contribution and defined benefit plans at (approximately) $3 million. How the defined benefit element of this would be managed was never clear. A more workable proposal that has been floated would be to cap IRA and DC account balances at $2 million.

Either of these proposals could be included in the 2021 tax reform effort.

While proposals to, e.g., eliminate the 401(k) tax exclusion and replace it with a tax credit have gotten some press, most view them as either too complicated or too expensive (or both) to gain much support, even among Democrat policymakers.

Non-tax retirement policy proposals that may be included in budget reconciliation legislation

We also note that, while there will of course be a struggle for “budget reconciliation shelf space,” a number of non-tax retirement policy proposals may make it into a budget bill, including:

Elements of the SECURE 2.0 and Cardin-Portman proposals.

Some version of Congressman Neal’s (D-MA and Chairman of the House Ways and Means Committee) automatic retirement plan proposal.

An expansion of the Saver’s Credit that was left out of SECURE 2.0 for budget reasons.

Outlook

At this point, it seems very likely that some version of the Biden/Democrat tax reform proposals, including income and investment tax increases, will be passed. The inclusion of the proposals directly affecting retirement policy (e.g., cutting retirement savings tax benefits for the high paid or a mandated automatic retirement plan) will depend on negotiations (presumably mostly within the Democratic caucus).

Timing will be an issue. No doubt the Democrats would like to get a bill passed and signed in time to affect 2022 rates/tax policy.

We will continue to follow these issues.