In the primary campaign, on both the Republican and Democratic side, there has been a lot of talk about changing our current income tax system – everything from “closing loopholes” to abolishing the IRS and switching to a “business flat tax” that some have compared to a value added tax. Later in the year – when the race has narrowed to two candidates – we’ll discuss retirement policy and the election in detail. In this series of articles, we provide a more thematic treatment of tax policy and candidates’ proposals as they affect 401(k) plans: How, broadly, would higher or lower income tax rates or taxes on capital, switching to a value added or consumption tax or closing loopholes affect the 401(k) tax “deal” – how would they affect 401(k)’s “tax appeal?”
In this article we review the tax benefits provided by the current system. In subsequent articles we will consider tax proposals of Republican and Democratic Presidential candidates.
The current system
First, the basics: below are the income tax rates applicable under the current system to joint filers in 2016 (throughout this article, when we discuss numbers, we are going to focus on joint filers).
|Taxable Income||Marginal Tax Rate|
|$0 – $18,550||10%|
|$18,551 – $75,300||15%|
|$75,301 – $151,900||25%|
|$151,901 – $231,450||28%|
|$231,451 – $413,350||33%|
|$413,351 – $466,950||35%|
Investment earnings – capital gains and dividends – are taxed at 15%, except for taxpayers in the 39.6% bracket, who pay 20%. In addition there is a 3.8% Medicare net investment income tax applicable to joint filers with adjusted gross income over $250,000.
The 401(k) tax deal
Under the current system, (non-Roth) 401(k) contributions 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 401(k) tax break is the value of the deferral of taxation of trust earnings.
In this article, generally, we’re only going to focus on non-Roth contributions. But this feature of 401(k) taxation can best be illustrated by comparing Roth and non-Roth contributions. Roth contributions are taxed as they go into the plan, earnings accumulate tax-free, and contributions plus earnings are not taxed when distributed. Assuming that the tax rate is the same at the time of contribution and distribution, however, the tax benefit is the same: Roth or non-Roth contributions, net of taxes, produce the same result.
Thus, the value of the 401(k) tax benefit is not the value of the tax exclusion, it’s the value of the deferral of taxation on trust earnings.
Second, where the participant’s tax rate is the higher at the time of (a non-Roth) contribution than it is at the time of distribution, the value of the 401(k) tax break is also the difference between those two tax rates. Thus, 401(k) plans may allow certain participants to shift income from higher-tax to lower-tax years. 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 401(k) 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 401(k) contribution does the same thing.
Let’s call the two benefits we just described the “explicit” benefits of the current 401(k) tax system. It is axiomatic that, under such a system, the employees who benefit the most are those with the highest marginal tax rate. Indeed, for the nearly half of American workers who pay no federal income taxes at all, there is no explicit tax benefit under this system.
The tradeoff – the quid pro quo for these tax benefits for higher paid/high marginal tax rate employees – is that an employer can’t have one of these plans unless low-paid (and low-marginal tax rate) employees also get benefits. In 401(k) plans this rule is implemented via the actual deferral percentage (ADP) test. As a result of this rule, to assure participation by low-paid employees, 401(k) plan sponsors provide matching contributions, “advertising” and automatic enrollment to drive low-paid employee participation.
Thus, to “buy” the explicit 401(k) tax benefits for high margin taxpayer-employees, the employer, under the current system, provides a benefit to low margin taxpayer-employees. Let’s call this benefit that is provided to low-paid employees the “implicit” benefit of the current tax system. What is the value of this implicit tax benefit? No one knows.
Changes to the current system that affect the value of explicit 401(k) tax benefits
Following this analysis, two sorts of changes to the current system will have an effect on the explicit tax benefits provided by the current system:
Reductions in marginal tax rates, and, especially, reductions in the progressivity of the current income tax system, will reduce the value of being able (under a 401(k) plan) to shift income from a high tax year to a low tax year. Senator Cruz (R-TX), for instance, would substitute for our current progressive income tax system a 10% flat tax (discussed in more detail in a future article). Under a flat tax, there is no value to shifting income from one year to another.
These sorts of changes will reduce the tax incentives for retirement savings built into the current system, including the incentive to employer-sponsors to provide implicit benefits to low-paid employees. And that (the reduction of retirement savings tax incentives) may raise more fundamental retirement policy issues: Should we provide tax incentives for retirement savings? And, if yes, how?