Category: Retirement

Originally published at Forbes.com on August 25,2020.  As of December 2024, this was by far the most-viewed article, with 4.75M views.

 

Round about a month ago, I took a closer look at Joe Biden’s retirement-related policy proposals, or, more specifically, those of the “Unity Task Force,” which had just released its final document.

One of the items in that document and on the Biden campaign website is a promise to “equalize the network of retirement saving tax breaks” — a proposal that generally translates to eliminating the tax advantages currently enjoyed by retirement savings accounts and replacing them with a “credit” or “match.” The idea is that the tax advantages, or “tax expenditures,” as they’re called, disproportionately accrue to relatively higher earners, and the hope of a change is to provide benefits in equal measure to all income groups.

But how this translates in practice is not clear. An article at Roll Call this morning picked up on the proposal, as did Courthouse News, but neither had more detail, referencing only a 2014 Urban Institute/Tax Policy Center proposal, which provided various hypothetical alternatives.

So what did that proposal suggest? It included a variety of options, including

• Reducing total available pre-tax savings (employer and employee) from (at the time) $51,000 to only the lesser of $20,000 or 20% of pay;
• Expanding the currently relatively-small “Saver’s Credit” (equal to 50% of the first $2,000 in retirement savings, only for relatively lower earners, up to $$19,500 for singles, $39,000 for couples; and phasing out quickly, to 20%, 10%, and ultimately nothing for singles with $32,500/couples with $65,000 in income) to stay at 50% for higher earners and phase out in a much more gradual manner instead; or
• Wholly removing any tax benefit for retirement savings and provide a credit of 25% instead (often this proposal includes a limit to the credit; this particular proposal doesn’t specify such; also, note that this was prior to the 2017 tax law which dropped tax rates).

Biden’s proposal sounds, well, fair enough. But what would happen, in practice?

Let’s start with a small point of clarification: strictly speaking, “401(k)” refers to the ability of a worker to defer a part of their pay for retirement savings purposes, and to avoid taxes until the money is ultimately withdrawn. The deferral of employer contributions is not a part of section 401(k) of the relevant IRS tax code. Does Biden want to remove the tax preference for both workers’ and employers’ contributions to retirement plans, or only the former?

The Urban Institute proposal assumed that higher-income workers would continue to save just as usual, even if they are on the losing end of tax changes. But would they continue to save through their employers’ 401(k)? And, likewise, if employers’ contributions no longer offered a tax advantage, would they continue to offer these plans, or to offer employer contributions to them?

As it is, “nondiscrimination” regulations require that employers design their plans to ensure that the amount of benefit received by lower-income workers is not too much less, proportionately, than highly-compensated employees, even though the latter are more likely to save and receive matches. The entire system is designed on the expectation that employers’ concerns lie largely with their higher earners and that they must be regulated into offering similar benefits to their lower earners. Would they be more likely, in these alternate circumstances (especially if benefits are capped and quite limited for higher earners), to simply boost pay instead so that these workers can seek out other forms of tax-advantaged investing?

To be sure, this isn’t generally an either-or situation. But employers evaluate their entire benefits cost and determine overall benefits & compensation budgets, shifting, at any one time, how much they allocate to retirement savings compared to pay raises. And this would surely be a consideration.

(Incidentally, in fairness, one further concern, that middle class savers who are currently urged by conventional wisdom to aim to save at least enough to receive their employer’s match, would aim for a lower target instead, that of the maximum “government-matched” contribution, might not be an issue: according to Vanguard’s 2020 survey, most savers do not target this “get the full match” level of savings at all. 34% of savers contribute less than needed to get the full match, a surprising 49% contribute more, and only 18% contribute exactly enough to get that full match, and nothing more.)

But there’s a final issue that’s even more concerning: this proposal doesn’t appear to recognize what really happens with retirement savings accounts tax advantages.

Here’s another example of such a proposal, a 2011 Brookings report:

“There is a formal economic equivalence between the incentives created by a deduction at a given rate and those created by a tax credit of a different rate. For example, a 30 percent matching credit is the equivalent of an income tax deduction for someone with a 23 percent tax rate. For every $100 contributed to a retirement account by an individual with a 23 percent tax rate, the individual would receive a tax deduction worth $23.”

These proposals appear to forget that tax advantages in retirement savings accounts are not simply a matter of deductibility, as one deducts mortgage interest or charitable deduction.

Instead, recall that in a Roth account, whether a 401(k) or an IRA, one pays taxes right away, then takes one’s money at retirement without paying further taxes.

In a traditional 401(k), one doesn’t pay taxes when making the contribution, but nonetheless must pay taxes upon withdrawing the money at retirement. This is the entire reason for the RMDs, required minimum distributions, to give the government its share without excessive delay.

But regardless of which type of account one elects, the principle is the same.

Imagine that the tax rate was entirely flat, say 20% for everyone, no deductions, no marginal rates. Your effective tax rate, measured as the proportion of the final account balance at retirement paid out in taxes, is 20% either way.

What’s the benefit of the tax advantage, then? It prevents workers from being double-taxed, that is, taxed on their investment return.

Here’s the math:

Imagine a 30 year career, where a worker has 3% pay increases each year and earns 6% in investment return each year.

With a 15% income tax rate, the tax-advantaged net tax rate at the end of the 30 years would be, of course 15%. But if there were no tax benefits, and if investment gains were taxed at the same rate, the effective tax rate would be 22%, considering the “cost” in taxation on the compounding of returns. If the income tax rate were 20%, the effective tax rate would be 29%. And a tax rate of 30% would result in an effective tax rate of 42%, in each case considering the proportion of the total investments paid as taxes over the years.

Hard to follow? Here’s a table to illustrate:

Here, “tax deferral, no Roth” is a scenario similar to capital gains, paying taxes only when you sell the stock. “Inside build-up taxed” is like an interest-bearing bank account, where you pay taxes on the interest every year. This is highly simplified just to provide an idea of what’s going on.

Now, reader, your own reaction might be: “what double taxation? It’s entirely fair to tax investment income!” But in either case, that means that the comparisons being offered are comparing apples to oranges.

Here’s another example: there have been proposals to switch from a “pure” tax deduction for charitable contributions to a tax credit instead. If the credit were set at 20% of the contribution, then anyone who pays income tax at a rate less than 20% would be a “winner” and anyone who pays taxes at a rate greater than 20% would be a loser.

But to remove the tax-deferral (or, in the case of the Roth, the removal of taxes on investment build-up), is wholly different conceptually. Yes, you can do the’ math of the long-term additional revenue the federal government would get by taxing investment gains (assuming they don’t find other tax advantaged savings, or stop saving altogether), and calculate, over the long term, how much the government could “spend” by giving tax credits for retirement savings instead, but it’s a much more complicated set of changes than it appears.

And, finally, here’s a comment by Biden adviser Ben Harris, made at a Democratic National Convention roundtable and cited by Roll Call:

“If I’m in the zero percent tax bracket, and I’m paying payroll taxes, not income taxes, I don’t get any real benefit from putting a dollar in the 401(k).” Harris isn’t wrong here — and, indeed, however much Mitt Romney was excoriated for saying that 47% of Americans don’t pay taxes, he was right. But there’s a place for both types of tax treatment, to accomplish two different purposes.

****

As a follow-up, I published the following “actuary-splainer” the next day:

Readers, after publishing my prior article, with the clunky title, “Joe Biden Promises To End Traditional 401(k)-Style Retirement Savings Tax Benefits. What’s That Mean?” I received, generally speaking, two types of feedback: first, challenging me with respect to my statements, in general, of Biden’s plan; and, second, asking for more of an explanation of what I mean, with respect to 401(k)s and taxes. As you might guess, I’m not going to turn down an opportunity to math at a question.

To back up briefly, the Biden proposal is this: rather than continuing the existing tax treatment for 401(k) plans, since this benefits higher earners disproportionately insofar as they save more and pay taxes at higher rates, he would instead provide a tax credit for retirement savings.

Here’s the full text of the Biden promise on the campaign website:

“Under current law, the tax code affords workers over $200 billion each year for various retirement benefits – including saving in 401(k)-type plans or IRAs. While these benefits help workers reach their retirement goals, many are poorly designed to help low- and middle-income savers – about two-thirds of the benefit goes to the wealthiest 20% of families. The Biden Plan will make these savings more equal so that middle class families can enter retirement with enough savings to support a healthy and secure retirement. President Biden will do so by:

“Equalizing the tax benefits of defined contribution plans. The current tax benefits for retirement savings are based on the concept of deferral, whereby savers get to exclude their retirement contributions from tax, see their savings grow tax free, and then pay taxes when they withdraw money from their account. This system provides upper-income families with a much stronger tax break for saving and a limited benefit for middle-class and other workers with lower earnings. The Biden Plan will equalize benefits across the income scale, so that low- and middle-income workers will also get a tax break when they put money away for retirement.”

And here’s the key section of a Roll Call article filling out some (but not many) details:

“Ben Harris, a Biden adviser who served as the nominee’s chief economist during his vice presidency, emphasized the equalization feature at a policy roundtable Aug. 18 during the Democratic National Convention. ‘This is a big part of the plan which hasn’t got a lot of attention,’ Harris said.

“Under current law, there will be some $3 trillion in tax benefits distributed to those saving for retirement over the next 10 years, Harris said. But those tax breaks are spread ‘incredibly unequally’ with low-income earners getting very little, he said.

“’If I’m in the zero percent tax bracket, and I’m paying payroll taxes, not income taxes, I don’t get any real benefit from putting a dollar in the 401(k),’ Harris said. ‘But if someone’s in that top tax bracket, they get 37 cents on the dollar for every dollar they put in there,’ he said.”

Now, what exactly does Biden have in mind? The campaign has not spelled out any particulars (and has not responded to a request for comment), but I have drawn on the existing discussion on the topic among politicians, pundits, and policy analysts (as partially cited in my prior article) to identify the intended plan as a tax credit, similar to the existing Savers’ Credit but more generous and expansive. Likewise, the existing proposals and discussion is not merely about expanding that credit but reducing or wholly eliminating 401(k) tax breaks to pay for it. Whether the envisioned credit would be capped or means-tested, and whether retirement savings accounts would retain any tax benefit, even that of taxing capital gains at lower rates, is unclear.

But, again, my final point in the prior article was that it is a misunderstanding of the nature of 401(k) (and similar) plans, to say that a top tax-bracket person would “get 37 cents on the dollar.”

The benefit of a 401(k), or IRA, or 403(b), is not a matter of a tax deduction. It is quite unlike a charitable contribution, or mortgage interest, or any other such true tax deduction.

The benefit of a retirement account is that the investment returns are not taxed.

This is plain to see for a Roth 401(k) or IRA, where contributions are made with after-tax earnings but at retirement, there is no further taxation applied.

But this is also true for a traditional IRA.

In a traditional IRA, contributions are made without taxes being applied first, but then ordinary income taxes are applied when the money is taken as a distribution.

Here’s a Roth IRA calculation, for the account growth for a single hypothetical year until withdrawal:

Pretax intended contribution amount x (1 – tax rate) x (1 + investment return), compounded = account balance at withdrawal

Here’s the calculation for a traditional IRA:

Pretax intended contribution amount x (1 + investment return), compounded x (1 – tax rate) = account balance at withdrawal

Basic arithmetic tells us that rearranging the order of multiplication doesn’t change the final result.

(What’s the benefit of one type of account versus the other? A traditional IRA shifts income from working years when it is, in principle, taxed at that person’s highest marginal rate, to retirement years when it is taxed at the full range of rates applying to them. A Roth IRA is better for people who are in lower tax brackets now, or who expect taxes to go up in the future, generally speaking.)

In any event, without the tax benefit, both the contributions and the investment return would be taxed — similar to a bank account (interest is reported as income for income taxes), a mutual fund (”distributions” are reported and taxed annually and the eventual additional increase in value taxed when sold), or stock holdings (where gains are taxed upon sale).

What does this mean?

I had presented a table of “effective tax rates” in my prior article. Here it is again:

This is a table of the reduction in final account balances, due to taxes, on a hypothetical 401(k) account, by comparing final balances

 

• with no taxes at all;
• with a Roth account;
• with a traditional 401(k) account, after taxes are applied;
• with no special tax treatment except the ability to defer taxes on investment income until withdrawal; and
• with the “inside build-up” of the investment returns taxed each year.

 

The point is to make it clear that the tax treatment is not to erase taxation on contributions (the taxes are still eventually paid) but to reduce the “extra” taxes otherwise due.

Still not sure what I mean? Here are two graphs, showing this hypothetical scenario with account balances, after taxes are applied, in the case of a 20% and a 30% tax rate, under the same highly-simplified conditions. Visually, the difference between the account balances with and without the favorable IRA tax treatment is much less than the reduction in account balances due to the taxes nonetheless still applied to IRAs.

Finally, how does this impact the promise of a tax credit instead of the existing tax benefit — which, again, is not a matter of deductibility but of avoiding taxes on investment gain? Because Congress measures costs over 10 year periods, and in the short term, the apparent “cost” of a traditional IRA is the tax deductibility (without considering that taxes are eventually paid), Congress might be tempted to game the calculations to overstate the “cost” in tax revenue foregone, in order to have more money to “spend” on tax credits. But the honest method would be to calculate the cost taking into account workers’ entire working lifetime and retirement years. (You might need an actuary or two.)

I’m not going to venture to attempt that here. But I will provide two very simple numbers:

If the weighted-average tax rate were 30%, based on highly-simplified calculations, the tax credit that could be offered by “spending” the added tax revenue of getting rid of the existing tax benefits, would be 21%. If the weighted-average tax rate were 20%, the available tax credit would be 14%.

In other words, there’s not much “free money” to be found here, and Congress would need to add caps or phase-outs if they wanted to make these credits truly appealing to lower earners. To repeat, what precisely the Biden campaign has in mind is unknown, and my intent here is to explain the issues as clearly as possible.

 

December 2024 Author’s note: the terms of my affiliation with Forbes enable me to republish materials on other sites, so I am updating my personal website by duplicating a selected portion of my Forbes writing here.