Tip Deduction Retirement Impact
The OBBB created a temporary deduction for up to $25,000 in qualified tip income. Highly compensated employees are not eligible for the deduction. The amount of the deduction is reduced by $100 for every $1,000 by which the taxpayer's modified adjusted gross income exceeds $150,000 ($300,000 for joint re-turns). For low earners, the new deduction could erase taxpayers' federal income tax liability altogether. Some have questioned whether the deduction could have an overall negative impact on low-income taxpayers' motivation to contribute to retirement accounts.
We asked two professors and authors of Tax Facts with opposing political viewpoints to share their opinions about whether the "no tax on tips" deduction will have a negative impact on lower-income taxpayers' retirement savings.
Below is a summary of the debate that ensued between the two professors.
Their Votes:
Their Reasons:
Bloink: Perhaps not initially, but once lower-income tipped workers realize the zero-sum—or even negative—tax implications, they'll definitely be discouraged from making pre-tax retirement account contributions. Those contributions will no longer generate the benefit of reducing tax liability for many low earners. Potentially negative tax consequences can even arise if the taxpayer decides they need to take an early distribution in a later year—an entirely realistic possibility when we're talking about lower-earning, often-younger employees.
Byrnes: Most lower-income employees that choose to fund 401(k)s at all are on autopilot. Many don't understand how the new tip deduction works in the first place or how it will interact with their retirement savings plan. This tip deduction will have no impact on lower-income taxpayers' retirement savings choices, if they're even proactively making pre-tax savings elections on an as-you-go basis instead of pre-set "auto-enrollment" type contributions.
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Bloink: With the $25,000 tip deduction, many lower-middle taxpayers will find that they don't owe any federal income taxes at all. Of course, that means they won't see any immediate tax benefits for the 401(k) contribution in the first place—and we can't deny the impact of an immediate tax benefit on retirement savings choices. In a situation where the taxpayer withdraws those funds in a subsequent year, they'll be forced to pay taxes--and maybe a penalty--on the distribution.
Byrnes: Employers who are worried about these types of negative impacts on savings choices can simply take steps to educate those taxpayers--and maybe even provide a Roth savings option, educating their employees about the potential benefits of this type of Roth program--not to mention the pitfalls of tapping retirement savings too early in their working years.
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Bloink: Contributing to retirement accounts could actually result in low-income taxpayers experiencing negative tax consequences--and once lower-income employees understand these potential consequences, they'll be discouraged from contributing to retirement accounts in the first place. We're talking about a situation where a low-income employee would actually be converting nontaxable income into taxable income by making the retirement contribution. Once taxpayers understand that tax detriment, they're highly unlikely to continue their ordinary retirement plan contributions.
Byrnes: Again, employers have options. They can choose to offer an employer match to further incentivize workers to contribute to retirement accounts. This new deduction does nothing but provide a tax benefit to some employees whose incomes tend to fluctuate and be most vulnerable to an uncertain economy.