In our prior articles in this series we discussed current 401(k) tax benefits generally and how they would be affected by Republican Presidential candidates’ tax reform proposals. In this article we discuss how the tax reform proposals of the Democratic Presidential candidates, former Secretary of State Hillary Clinton and Senator Bernie Sanders (I-VT), would affect 401(k) tax benefits.
As in our prior articles, our discussion is “thematic.” We aren’t going to get deep into the numbers; rather we discuss the general effect of different sorts of proposals. And, as in our prior articles, when we talk about tax rates we are generally talking about those that apply to joint filers.
Democratic proposals generally
To frame the issue: as we discussed in our first article, the two key tax benefits of 401(k) savings are deferral of taxation of trust earnings and income shifting. Our question: how would the Clinton and Sanders proposals affect those tax benefits? In that regard, both Democratic candidates propose similar reforms: (1) an increase in taxes on investment earnings (capital gains and dividends); (2) a cap on “deductions” at 28%; and (3) a steepening of the progressivity of income tax rates – generally increasing taxes on higher income taxpayers.
We note that Clinton and Sanders’s proposals have not been pulled together as comprehensive “tax plans,” and our analysis in some cases involves some assumptions about how a given proposal would work.
Increasing taxes on investment earnings
Both Clinton and Sanders propose significant increases in taxes on capital gains and dividends.
Clinton would increase taxes across the board for taxpayers making more than $5 million; thus, capital gains and dividend tax rates for these taxpayers would rise 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:
Thus, unless the taxpayer holds the investment for the full six years, the capital gain 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.
Sanders taxes investment income at even higher rates – generally he would tax capital gains for taxpayers making more $250,000 at (generally increased) ordinary income tax rates.
28% cap on deductions
Both Clinton and Sanders 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%. It’s unclear whether this cap would apply to the 401(k) contribution exclusion. For purposes of this article we will assume that, like the recent Administration proposals, it would apply.
Steepening the progressivity of income tax rates
Both Clinton and Sanders would increase tax rates on higher income taxpayers, Sanders (again) more so than Clinton. Clinton would raise the rate on taxpayers making more than $5 million from 39.6% (currently) to 43.6%.
Sanders would increase rates across the board by 2.2% and then increase rates further on incomes over $250,000.
Sanders Income Tax rates
|Taxable Income||Current Marginal Income Tax Rate||Sanders Marginal Income Tax Rate|
|$0 to $18,550||10%||12.2%|
|$18,550 to $75,300||15%||17.2%|
|$75,300 to $151,900||25%||27.2%|
|$151,900 to $231,450||28%||30.2%|
|$231,450 to $250,000||33%||35.2%|
|$251,000 to $500,000||33% (to $413,350)
35% ($413,351 – $466,950)
39.6% ($466,951 – $500,000)
|$500,001 to $2,000,000||39.6%||45.2%|
|$2,000,001 to $10,000,000||39.6%||50.2%|
|$10,000,001 and up||39.6%||54.2%|
Value of deferral of taxation of trust earnings
Let’s begin by considering, independently, the effect of these changes on the value of the 401(k) deferral of taxation of trust earnings. Generally:
A cap on the 401(k) tax exclusion will decrease its value.
An increase in marginal tax rates will decrease its value. (This result is somewhat counter-intuitive. It turns out, however, if you increase marginal income tax rates but do not increase the tax on investment earnings, the value of 401(k) deferral of taxation of trust earnings goes down.) This effect is, however, generally much less significant than the effect of the 28% cap.
These changes, obviously, point in different directions. Their net effect will depend on how big the increases in taxes on investment earnings are relative to the 28% cap and the increases in marginal tax rates.
With respect to Clinton’s proposal, whether the net effect of her tax proposals on 401(k) tax benefits is “negative” or “positive” will depend on what capital gains holding period you assume. If you assume that the outside-the-plan asset is held for six years and thus gets the current 20% capital gains rate (with, for incomes over $5 million, a 4% surcharge), then the “negative” effect of the deduction cap outweighs any “positive” effect (e.g., for incomes over $5 million) of higher capital gains rates. Thus, the net effect is to reduce the value of the 401(k) deferral of taxation of trust earnings. On the other hand, if you assume the asset is “turned over” in the first couple of years, and that the outside-the-plan capital gains rate is the same as or close to the ordinary income tax rate, then the net effect would be to increase the value of the 401(k) deferral of taxation of trust earnings.
Sanders’s proposal is, in this regard, more straightforward. Taxing capital gains at ordinary income tax rates (for incomes over $250,000) will – even with the 28% cap – generally increase the value of the 401(k) deferral of taxation of trust earnings.
Value of income shifting
As we said in our article on Republican proposals, increasing the progressivity of marginal income taxes generally increases the value of being able to shift income from a higher-tax year to a lower-tax year. The 28% deduction cap, however, significantly reduces this effect and, in addition, puts a ceiling on income shifting gains at the higher rates Sanders proposes. On balance, considering the two proposals together (higher tax rates/increased progressivity plus the 28% cap), the value of income shifting is, under the Democrat candidates’ proposals, generally reduced but remains significant.
While Democratic proposals to increase taxes on investment income and increase the progressivity of marginal tax rates would tend to increase the tax benefits of saving in a 401(k) plan, the 28% cap (if it applies to the 401(k) exclusion) would generally reduce those benefits. Where taxes on investment income are especially high (e.g., under Sanders’s proposal or where the Clinton six-year holding period is not met), the value of the 401(k) deferral of taxation of trust earnings would go up. The 28% cap would generally reduce, but not eliminate, the value of income shifting, which would remain significant.