With President-elect Biden potentially having a Democrat-controlled congress, we’ve received a lot of questions regarding Biden’s tax proposal to change how 401(k) contributions are deducted.
First remember we won’t know which party controls Congress until January when Georgia has the runoff election for our two Senate seats. Making any financial changes before then would be speculation in our opinion. Your financial plan accommodates the tax laws as they are today. When change comes, then you pivot if needed. Second, changes are not guaranteed nor immediate.
Biden’s campaign tax plan proposed equalizing the tax benefits of retirement plans. The proposed change would provide a tax credit of approximately 26%, regardless of your tax bracket. With our current structure, saving for retirement pre-tax benefits higher-income taxpayers more than it does lower income taxpayers, because a pre-tax contribution reduces the tax liability by the employee’s marginal tax rate.
Under current laws, for example, two employees both save $10,000 pre-tax to their 401(k) plan at work. John is in the 37% tax bracket, married filing jointly with an income of $630,000. His 401(k) contribution yields him a $3,700 tax break by lowering his taxable income. Bob, who makes the same pre-tax contribution, is in the 22% tax bracket, a single filer with an income of $70,000, so his contribution saves him $2,200 in taxes.
Under the proposed change, a 401(k) contribution would be included in an employee’s income, but the taxpayer would then receive a 26% tax credit to reduce the tax liability. Therefore, both John and Bob would receive a $2,600 tax credit for their $10,000 retirement plan contributions. While this slightly benefits Bob, the change could cost John $1,100. Full details of the change have not been fleshed out, so there are still many questions as to how this would work and whether it would be a refundable tax credit.
Without further details on the credit, and not knowing the other tax deductions a high-income earner might have, specific advice is nearly impossible. However, we suspect those employees who would receive less of a tax credit might opt to save using the Roth 401(k) option. Currently there is no income limit to a Roth 401(k). Contributions are after-tax and then grow tax free as distributions are tax free in retirement—a much better deal than being taxed on the contribution, receiving a lower tax credit, and then being taxed on the distribution in retirement. Withdrawals for a Roth 401(k) must begin at age 72, but not if the Roth 401(k) is rolled into a Roth IRA.
While the proposal to equalize the benefit might encourage more company-sponsored retirement plan participation among some lower income families, it may not change the attitudes of those employees who live paycheck to paycheck. Under the proposed change, a retirement plan contribution would decrease an employee’s take-home pay dollar for dollar.
Regardless of how runoff elections turn out, your financial plan is built to accommodate tax changes. This will not be the first tax law change you’ve encountered nor will it be the last. When laws change, you need to look at your entire financial plan and tax situation before making any moves. A trusted financial planner and tax consultant can help you see the whole picture. If you have questions on how your plan can accommodate change, the experts at Henssler Financial will be glad to help:
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