The election of Joe Biden as president may clear the way for many changes in the retirement planning landscape. As of this writing, some U.S. Senate races are still undecided, so the ultimate balance of power in the Senate can certainly affect the content and implementation of these proposals.
Biggest Change In Qualified Plans in Almost 50 Years
Over 30% of Americans contribute to tax-preferenced retirement plans (401(k), IRAs, 403(b), 457 and MEPs). Participants have invested $58M in 401(k) plans alone. The funding currently accounts for over $29 trillion dollars. The Democratic proposals would shift some of the benefits of tax deferral in traditional retirement accounts toward lower- and middle-income earners with the goal of encouraging additional saving by those taxpayers.
Biden’s proposals convert the current deductibility of traditional retirement contributions into matching refundable tax credits for 401(k)s, individual retirement accounts (IRAs), and other types of traditional retirement vehicles, such as SIMPLE accounts.
Biden’s proposal would eliminate deductible traditional contributions and instead provide a 26% refundable tax credit for each $1 contributed. The tax credit would be deposited into the taxpayer’s retirement account as a matching contribution. Existing contribution limits would remain, and Roth-style tax treatment would be unaffected. (see comparisons below).
A full comparative analysis an be found below.
Traditional retirement accounts allow taxpayers to defer paying tax on contributions, deducting the contribution when calculating adjusted gross income (AGI). Taxpayers can let the contribution earn returns when invested, eventually paying tax on the distributions when the funds are withdrawn.
Traditional treatment can be contrasted with Roth-style tax treatment, where taxpayers pay income tax on the contribution up front but can withdraw the principal and return tax-free upon distribution.
These tax treatments are equivalent (assuming the contribution and tax rates are identical over time), while ensuring the tax code is neutral with respect to saving and consumption decisions.
Because the individual income tax is progressive, the value of a tax deduction rises as income increases. For example, a taxpayer in the top marginal tax bracket receives a $37 tax benefit for every $100 contributed into a retirement account, while a taxpayer in the bottom bracket would only get a $10 tax benefit for the same $100 contribution.
President-elect Biden’s proposal to offer a flat 26% tax credit for retirement contributions seeks to equalize this treatment. Compared to current law, the flat credit would provide a larger benefit to lower-income earners and reduce the benefit to higher-income earners.
This can be illustrated by converting the proposed 26% tax credit into a tax deduction of equal benefit, allowing us to see how much of a deduction would need to be provided to give the same benefit as the matching tax credit.
To see how, consider the after-tax cost of a taxpayer contributing $100 into a traditional account. The 26% credit is equal to a deduction at a 20.5% marginal tax rate for all taxpayers, independent of their income level: If a taxpayer contributed $100 and received a 20.5% deduction, their after-tax cost of contributing $100 to their retirement account would be $79.50.
Under the proposed changes, if the taxpayer had no deduction but contributed $79.50 and received a 26% matching credit, they would have contributed a total of about $100 at the same after-tax cost.
Additionally, this credit is expected to be roughly revenue neutral, with the elimination of deductibility offsetting the revenue lost from the new tax credit.
In effect, the proposal takes the rising value of deductibility by income level and converts it into a flat deduction. This provides a new benefit to taxpayers in lower income tax brackets, while providing slightly worse treatment for higher earners.
A taxpayer in the 12% tax bracket earning $35,000 would receive a 12% deduction under current law for their traditional retirement contributions, but under Biden’s proposal would see an effective deduction at a 20.5% marginal tax rate (higher than currently) when they receive the 26% matching tax credit.
By contrast, a taxpayer in the 37% tax bracket would only receive an equivalent deduction at a 20.5% marginal tax rate, rather than a deduction at a 37% marginal tax rate they receive under current law.
This means that taxpayers in the 10% and 12% tax brackets (roughly up to $80,250 filing jointly) would benefit from this change, while those in the higher brackets would lose some of the value of traditional accounts when compared to current law.
Proponents of this change argue that this would help encourage lower income earners to save by providing a salient reward for saving in the form of a matching tax credit and raise the value of saving on the margin, as higher earners tend to contribute more often (see table below).
They also argue that higher earners would not decrease their savings on net, as they often use retirement accounts to shift other savings they already had from taxable to non-taxable accounts.
There are drawbacks to this idea, however.
First, Roth-style retirement accounts will become more attractive to higher earners, which could shift savings away from traditional accounts.
Second, this plan would reduce the tax benefit of traditional retirement accounts for those earning above $80,250 but under $400,000. This proposal would be paired with additional changes, such as establishing an “auto-IRA” for lower-income Americans.
Pension Rehabilitation Administration
The change in administration and Senate control also paves the way for the enactment of the Butch Lewis Act which bails out multiple employer plans at the expense of the taxpayer. The Act established the Pension Rehabilitation Administration (PRA) within the Department of the Treasury and a related trust fund to make loans to certain multi-employer defined benefit pension plans.
To receive a loan, a plan must be either in critical or declining status (including any plan with respect to which a suspension of benefits has been approved), which is expected to apply to 96% of multi-employer plans in the future.
The Treasury must issue bonds to fund the loan program and transfer amounts equal to the proceeds to the trust fund established by this bill. The PRA may use the funds, without a further appropriation, to make loans, pay principal and interest on the bonds, or for administrative and operating expenses.
The bill amends the Employee Retirement Income Security Act of 1974 (ERISA) to allow the sponsor of a multi-employer pension plan that is applying for a loan under this bill to also apply to the Pension Benefit Guaranty Corporation (PBGC) for financial assistance if, after receiving the loan, the plan will still become (or remain) insolvent within the 30-year period beginning on the date of the loan.