With the election approaching, we begin a series on the Presidential candidates’ positions as they may affect retirement policy. In this article we review the possible effect of Vice President Biden’s tax proposals.
The principles that we discuss will generally affect defined benefit and defined contribution plans/plan participants in the same way. That is, the tax benefit from saving in a tax qualified plan is generally the same across different plan types – either through employer contributions on the participant’s behalf to a DB plan or 401(k) salary reduction contributions.
Biden proposals that directly affect retirement policy
Vice President Biden’s campaign website includes several proposals that directly affect the private, single-employer retirement system, including:
“Equalizing the tax benefits of defined contribution plans”
“The Biden Plan will equalize benefits across the income scale, so that low- and middle-income workers will also get a tax break when they put money away for retirement.” The Urban-Brookings Tax Policy Center (TPC) explains that this proposal “would make tax incentives for retirement saving more progressive by replacing the deduction for traditional individual retirement account (IRA) and defined-contribution pension plan contributions with a refundable tax credit ….”
Generally, the tax effect of this proposal would be to re-target tax benefits away from the high paid/high tax rate employees, for whom a tax deduction would be more valuable than a tax credit, and towards low paid/low tax rate employees, for whom a tax credit would be more valuable than a tax deduction. This benefit is even larger in the case of high earners in professional partnerships that may be contributing hundreds of thousands of dollars in a year to a cash balance or similar plan.
“Giving small businesses a tax break for starting a retirement plan and giving workers the chance to save at work”
“The Biden Plan will call for widespread adoption of workplace savings plans and offer tax credits to small businesses to offset much of the costs. Under Biden’s plan, almost all workers without a pension or 401(k)-type plan will have access to an ‘automatic 401(k),’ which provides the opportunity to easily save for retirement at work – putting millions of middle-class families in the path to a secure retirement.”
There are a number of proposals currently being considered, as part of the development of “SECURE 2.0” legislation, both to provide additional financial incentives for small plan formation and to increase the number of 401(k) plans providing for auto-enrollment. And House Ways and Means Committee Chairman Neal (D-MA) has his own auto-enrollment proposal.
Proposals that affect the “economics of saving”
Many of Vice President Biden’s broader tax proposals will have an effect on the economics of saving in, e.g., a 401(k) plan – how much “cheaper” it is to save inside a plan than outside a plan.
As a useful background to this discussion, please see our 2016 article on the Trump and Clinton tax proposals(many of which are, in some version, included Vice President Biden’s proposals). Also useful are articles we have posted on The value of retirement benefits and tax policy, Capital gain and dividend taxes, and The effect of tax reform on retirement savings – corporate tax.
Vice President Biden’s proposals include:
Increasing taxes on income over $400,000 from 37% to 39.6%. Generally, as tax rates go up, the value of the tax benefit of saving in a 401(k) plan also goes up (relative to non-plan savings). This marginal increase in the 401(k) tax benefit for high paid/high tax individuals could, however, be eliminated by the “deduction cap” discussed below.
Taxing capital gains at ordinary income tax rates on income above $1 million. As with income taxes, an increase in the capital gains tax paid by high paid/high tax individuals would increase the tax benefit of saving in a 401(k) plan vs. non-plan savings. Here, the size of increase (nearly doubled from a current level of 20% to 39.6%), and the resulting tax incentive, is much greater and more significant. This benefit is even larger in the case of high earners in professional partnerships that may be contributing hundreds of thousands of dollars in a year to a cash balance or similar plan.
Capping the deduction/tax benefit of itemized deductions at 28%. The most important question at this point is, will this cap apply to, e.g., 401(k) contributions? If it does, it would generally significantly decrease the value of the 401(k) tax benefit for taxpayers with marginal tax rates above the cap.
Phasing out the qualified business income deduction income above $400,000. Many viewed the Trump Tax legislation’s 20% deduction from individual income tax for qualified business income from a partnership, S corporation, or sole proprietorship as creating a disincentive for some small businesses to establish or continue to maintain tax qualified plans. The elimination of that deduction for income above $400,000 would, under this logic, increase the incentive for small plan formation.
Increasing the corporate tax rate from 21% to 28%. As we discussed in our article on the Trump Tax legislation, the 2018 reduction in the corporate tax, from 35% to 21% significantly enhanced the 401(k) retirement savings tax benefit for all savers. That’s because tax qualified retirement plans/trusts are tax-exempt entities and do not pay tax at the “shareholder level.” They do, however, indirectly pay the corporate level tax; that is, the earnings from their investment in a corporation are subject to tax, at the corporate level. Thus, the reduction in taxes at the corporate level translated into increased returns to retirement plan investors, increasing the tax benefit of saving in a tax qualified retirement plan. The Vice President Biden proposal to increase the corporate tax would (partially) reverse this result.
Different sponsors will have different views on whether Vice President Biden’s proposals generally designed to point more retirement savings tax benefits at lower paid employees are a good idea or good for the system overall.
On the one hand, they are likely to increase low paid employee interest in saving. On the other hand, many view high paid employee buy-in resulting from current tax incentives as critical to sustaining employer commitment to the current system, with the concern about low paid employee coverage better addressed through the Internal Revenue Code’s nondiscrimination rules.
Vice President Biden’s other tax proposals are, for the qualified plan system, something of a mixed bag. Increases in income and capital gains tax rates will encourage qualified plan savings. But a deduction cap – if, e.g., it apples 401(k) contributions – would discourage participation by certain employees, and the increase in the corporate tax rate would reduce returns to all qualified plan savers.
We will continue to provide articles on the candidates’ proposals as they might affect retirement policy as the election approaches.