EDITOR NOTE: If Biden and Harris win in the upcoming presidential election, their 401(k) tax proposal would put any high earner at a disadvantage; lower earners at a better standing. Contrary to what some think, this wouldn’t be the end of your wealth prospects if you’re on the disadvantaged side of the income bracket. There are plenty of alternatives, in fact, plenty more that go beyond the scope of this article. But for starters, here are a few important points to consider as we head deeper into this highly-divisive election season.
It's an election year and you know what that means: Proposals are cropping up from both sides of the aisle that promise to make your life easier. One, supported by the Biden-Harris ticket, is a change to the tax rules for 401(k) retirement plans. Given that roughly half of Americans are participating in a workplace-sponsored retirement plan, the proposed tax adjustments aren't tiny changes that only affect the wealthy. So the big question is, if Biden can put his plan into action, how would it affect you?
How 401(k) tax perks work today
Biden is proposing to equalize the tax benefits for 401(k) contributions across income levels. To understand what that means, it helps to revisit how those tax benefits work today. Under current rules, your 401(k) contributions are made with tax-free dollars. The amount you save by not having to pay taxes on those contributions is dependent on your tax bracket. If you are in the 22% tax bracket, you save $0.22 for every $1 you contribute. But if your marginal tax rate is 37%, you save $0.37 for each $1 contributed.
The table below shows the dollar value of tax-free contributions at different income levels, assuming each worker is saving 10% of their income to a 401(k). The 10% savings assumption is used for consistency, but it's admittedly flawed -- because someone making $25,000 annually may not have the means to save that much. Also, the tax rates shown are for single filers, based on the 2020 tax tables.
As you can see, the higher income saver gets more value under the current rules. That's Biden's issue with the system; it disproportionately benefits higher income individuals who already have the means to save more, because the tax credits are worth more to them.
The flat-rate tax credit pitch
In 2018, Ben Harris, an advisor to Biden, published an article in The Wall Street Journal on reforming 401(k) tax rules. At the time, Harris said, "Rather than making the subsidy dependent on tax rates, savers should get a transparent upfront credit for putting money into a retirement account -- say 25% of contributions." While Biden's 2020 proposal hasn't specified the rate he'd recommend for the tax credit, some sources speculate that it could be 25% or 26%.
A 25% flat rate applied across the board on contributions would raise the tax benefit for lower-income individuals and reduce it for higher-income individuals. The table below compares the dollar value of contribution tax breaks based on income tax brackets versus the flat, 25% rate.
Other options for retirement savings
Politicians float tons of big ideas before elections, and many of those ideas will either evaporate into thin air or get reworked into something different. This Biden proposal is no different. If it does get pushed through in its current form and you are one who will benefit -- great. You'll have a little more money available to save for retirement. If you are on the negative side of this equation, you can evaluate shifting some of your retirement contributions elsewhere, such as your Roth IRA, designated Roth 401(k) contributions, or even a taxable brokerage account.
Roth contributions aren't tax deductible, though your investment earnings grow tax-free over time and qualified retirement withdrawals are also tax-free. Your taxable brokerage account offers no tax perks, but you don't have any withdrawal restrictions, either.
At the end of the day, you still have to save for retirement and you still have to pay your taxes. If a change in the political climate shifts around some of those details, so be it. If you keep on saving and investing, your retirement plan won't be made or broken by this proposal.
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Originally posted on The Motley Fool