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The effect of tax reform on retirement savings – income and investment taxes

It looks like tax reform will be a high legislative priority for President-Elect Trump and the Republican-controlled Congress. In the first of two articles on the effect of tax reform on retirement savings tax incentives, we begin with a discussion of the tax reform process and the challenges it will present. We then discuss current income and investment taxes and the incentives they provide for saving in, e.g., a 401(k) plan. Finally, we discuss the income and investment tax proposals of House Republicans and of President-Elect Trump and how they might change the retirement savings tax deal.

In out next article we will discuss the effect of corporate tax reform proposals on retirement savings tax benefits.


Let’s begin by discussing some of the moving parts in the process of reforming the Tax Code.

Republicans control both the House and the Senate, but Democrats can still block “normal” legislation with 41 votes in the Senate. Republicans can, however, move legislation in the Senate with only 51 votes through a Reconciliation Bill – that, in fact, was how the Bush 2001 tax cuts were passed. But the Republicans will only get one shot at Reconciliation, and they are probably going to want to include Affordable Care Act legislation in a Reconciliation Bill.

Moreover, while President-Elect Trump has endorsed elements of the House Republicans’ tax reform plan, his proposal (again, as we’ll discuss below) differs in some respects. Senate Republicans, very much including Senate Finance Committee Chairman Hatch (R-UT), will also have their own views on tax reform priorities. And it’s certainly conceivable that Republicans may make an effort to get some Democratic support.

All of the foregoing – complications with a Reconciliation Bill and negotiations between House Republicans, Senate Republicans, House and Senate Democrats and the White House – will take time.

And the complexity of the process – and the number of different “players” – makes any prediction now of what tax reform will ultimately look like pretty speculative.

In the rest of this article, we’ll review the proposals of House Republicans and President-Elect Trump and how they may affect the retirement savings “tax deal.” Even if the end-product of the tax reform process is significantly different from the House Republican and Trump proposals we discuss, however, a review of those proposals will give readers a feel for the moving parts in this process and how they may affect retirement benefits.

We begin with a brief discussion of what that retirement savings tax deal currently is.

Retirement savings tax benefits – current law

Generalizing: under the current income/investment tax 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.

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 retirement savings tax benefit is the value of the non-taxation of trust earnings. This point must be emphasized: the value of the 401(k) tax benefit is not the value of the tax exclusion, it’s the value of the exemption from taxation of trust earnings.

Second, where the participant’s tax rate is higher at the time of (a non-Roth) contribution than it is at the time of distribution, the value of the retirement savings tax benefit is also 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.

We have posted a brief article that discusses this tax treatment: How Much Does My 401(k) Plan Save Me In Taxes?

Proposed changes to the current system that affect the value of retirement savings tax benefits

Following this analysis, two sorts of changes currently under consideration will have an effect on the retirement savings tax benefits provided by the current system:

Reductions in the tax on investment earnings will reduce the relative value of the non-taxation of trust earnings.

Reductions in marginal tax rates, and, especially, reductions in the progressivity of the current income tax system, will reduce the value of being able to shift income from a high tax year to a low tax year.

Income and investment taxes

The following chart summarizes current law income and investment tax rates and the rates House Republicans are proposing.

Current and Proposed (by House Republicans) Income and Investment Tax Rates (2016 tax rates)
Taxable Income Current Income Tax Rates House Republicans Proposed Income Tax Rates Current CG/Dividends Tax Rates House Republicans Proposed CG/Dividends Tax Rates
$0 – $18,550 10% 0%/12% 0% 0%/6%
$18,551 – $75,300 15%
$75,301 – $151,900 25% 25% 15% 12.50%
$151,901 – $231,450 28%
$231,451 – $413,350 33% 33% 16.50%
$413,351 – $466,950 35%
$466,951+ 39.6% 20%

President-elect Trump would (more or less) adopt the House Republicans’ proposed income tax rates. But he would keep the current investment (capital gains and dividends) tax rates.

In addition, under current law there is a 3.8% Medicare Net Investment Income tax that (oversimplifying somewhat) applies to joint filers making over $250,000. Both House Republicans and President-Elect Trump would eliminate that tax.

Connecting the dots … effect of proposed changes to investment taxes

Thus, both the House Republicans and President-Elect Trump would reduce taxes on investment by eliminating the 3.8% Medicare NII tax. House Republicans would go further, significantly reducing investment taxes across the board. These changes would reduce the value of the retirement savings tax benefit and make, e.g., contributing to a 401(k) marginally less attractive for taxpayers in those brackets in which the investment tax would be reduced.

… effect of proposed changes to income taxes

Some general observations about this issue. When considering the value of being able to shift income from one (higher tax) year/bracket to another (lower tax) year/bracket, the key factor is the difference between the two rates. Thus, the value of income shifting could go up even if marginal rates go down, if the difference between the rates is greater.

In this regard, the House Republican proposal (which President-Elect Trump has endorsed) is a mixed bag. Rates overall will be squeezed. But consider the different tax rate a taxpayer earning $85,000 will pay if she is able to shift $10,000 in income from the current year to a year when she will earn, say, only $50,000. Under current rules, she shifts income from a 25% tax rate year to a 15% tax rate year. Under the House Republican proposal, she would shift income from a 25% tax rate year to a 12% tax rate year, which is, in effect, a better deal.

The analysis here is very complicated and, as we said, a mixed bag. We raise this issue only because many savers will have it in the back of their mind that they will be in a lower tax bracket when they retire. In that situation, shifting income from a higher (pre-retirement) tax bracket to a lower (post-retirement) tax bracket can provide a pretty significant payoff. So tax brackets – and not just investment taxes – will matter for retirement savings tax policy. But how they will matter is typically under-analyzed, their effect is implicit rather than explicit, and they will matter more to some participants (who may anticipate a “lumpy” lifetime income) than to others (who may anticipate a “flatter” lifetime income).

Deduction cap

The House Republicans’ and President-Elect Trump’s tax proposals have been criticized for, among other things, reducing tax revenues and thus threatening to increase federal debt. It is very possible that, in response to those criticisms, the parties to negotiations will, e.g., modify some proposals and look for revenues elsewhere, e.g., by “closing loopholes.” With respect to retirement savings tax incentives, this may take the form of capping tax benefits for higher paid individuals.

In that regard, the Obama Administration has proposed capping the value of the exclusion for defined contribution (and IRA) contributions at 28% – so that, e.g., a taxpayer in the 33% bracket would only get a 28% exclusion and would pay, in effect, a 5% tax on a 401(k) contribution. A similar proposal was made in 2014 by (then) Chairman of the House Ways and Means Committee Dave Camp (R-MI). The Obama Administration has also proposed capping the total DB, DC and IRA benefits a taxpayer could accumulate at $3.4 million.

It is possible – perhaps in negotiations with Democrats – that proposals for one or both of those caps on retirements savings tax benefits may come up. The inclusion of a 28% exclusion cap, especially, in any final tax reform deal would significantly reduce the tax value of retirement savings for some taxpayers.

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We will continue to follow this issue as it develops.


What to Read Next

Republican Tax Reform proposal – effect on retirement savings policy

In this article we review the “framework” for tax reform released September 27, 2017, by Republican Congressional leadership and how it may affect retirement savings policy. Process Quoting the document released by Republican leadership: This unified framework serves as a template for the tax-writing committees that will develop legislation through a transparent and inclusive committee… Read More