How his 401(k) proposal impacts you
President Joe Biden’s campaign contained a very provocative statement:
“The current retirement 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 statement shares what we have known all along — the tax system tends to favor the rich at the expense of the poor, no matter the progressive tax rates. After all, the complicated endless structures, the bias towards unearned income, carried interest loopholes, and other ways and means of accounting have led to a situation where the top 400 families pay a mere 23% as tax compared to the 24.2% that the bottom half of the population pays. No wonder Warren Buffet has lamented the fact that he pays a lower tax rate than his secretary.
President Biden is now attempting to nullify at least one of these inequalities — the deductions on contributions to the 401(k). Let’s break the topic down into more understandable chunks; after all, the tax code is one of the most important factors in our personal finances, despite the fact it’s dry as bone dust.
The current system
A refresher on the 401(k):
- you contribute
- you get a deduction on your taxable income equivalent to your contribution (up to $19,500 annually)
- your contribution + any match that your employer may have contributed continue to earn tax-free
- you retire (or are close to retiring)
- you withdraw some amount to fund your retirement
- you pay tax on what you withdraw
The point that is being changed now is point number 2; how much of a deduction you get when you contribute.
The current system is simple, though unequal. It gives you a deduction of how much you actually contribute. If you contribute $1000, that is how much you can deduct from your taxable income. If your income is $10,000, it becomes $9000 for the IRS. If it is $50,000, it becomes $49,000. Sounds fair, doesn’t it?
Not really. For someone who pays 10% of their income as tax based on their earning, the savings are just $100. On the other hand, for someone who pays the top rate of 37%, it would save them $370 for the same contribution.
Not that fair now, is it?
The proposed system
The system that the President is proposing has two main changes from the current one:
Instead of a tax deduction for contributing to your 401(k), you will now receive a tax credit. What that means in practice is, if your income is $10,000, and you contribute $1000, your taxable income remains $10,000. Suppose the tax works out to $1000 (at a rate of 10%). Your tax on $1000 will be calculated and considered as paid, i.e., it will be a tax credit at the rate of 10%, which is $100. So, you will only have to pay the remaining $900. In effect, it doesn’t make a huge difference to you, but in conjunction with the other change, it does.
The second change is that everyone will get this tax credit calculated at the same rate (the number being suggested is 20.5%). So, for your $1000, you will receive a credit of $205, no matter what tax rate applies to you.
This change will be advantageous to those paying below that rate (say 10%) and not-so-advantageous for those paying above that (say 37%).
But wait a minute, what happens if you’re left with some extra tax credit? After all, only $100 is owed on the $1000, at the 10% rate. Well, you can use that to pay off tax on other income, or — you can get a refund!
Effect on nest-egg by maximizing savings
So, how much can you save if you put the entire savings away?
Let us put down some assumptions. Suppose you contribute the maximum every year — $19,500. Let us also assume that you earn $40,000 annually, after deductions, including the $12,550 standard deduction. That effectively means that your actual earning would be somewhere in the range of $52,550 to $60,000. That should cover a lot of us. Let us also calculate for someone earning $50,000 after deductions. This would cover some of the higher-earning members amongst us, those who earn $62,500 to $70,000, or even more, depending on the deductions.
Earning: $40,000, Contribution: $19,500
- Current system: You would only pay tax on $21,500 ($40,000 less $19,500). That would work out to $2150.
- Proposed system: You would pay tax on the entire $40,000, which is $4000. However, you would receive a tax credit of 20.5% of your contribution of $19,500, which is $3997.5. You would therefore pay a princely sum of $2.50 as tax.
- Tax Saving: $2147.5
Earning: $50,000, Contribution: $19,500
- Current system: You would only pay tax on $30,500 ($55,000 less $19,500). That would work out to $3050.
- Proposed system: You would pay tax on the entire $50,000, which is $6748.38. However, remember your tax credit of $3997.5? You would only have to pay the difference, i.e., $2751.38.
- Tax Saving: $298.62.
Effect of the savings annually
If you invest this bonus saving every year, this is the extra nest-egg that you will accumulate (at about 8%):
- @ $300 annually for 30 years — $36,000
- @ $2150 annually for 30 years — a whopping $257,000!
Basically, for the lowest-earning members of us, President Biden’s simple proposal can lead to a quarter of a million dollars more in our retirement accounts! That isn’t a bad deal at all for an obscure change in the tax code.
Also, these don’t have to be theoretical savings. If indeed the tax credit is refunded, you have no excuse not to save that windfall.
What to do if you are losing out
In the examples above, you would have seen that the savings start tapering off the more you earn. What do you do when you cross over to the other side — when the change becomes disadvantageous to you?
Well, in those cases, you may consider shifting to a Roth IRA instead of a 401(k). In a 401(k), you will be paying taxes partially now (at your effective tax rate less 20.5%) in addition to paying at withdrawal. With a Roth IRA, you need to pay the tax right now, but you can withdraw it tax-free when you retire.
Using simple ways to save money that you aren’t used to seeing in your bank account is an excellent way to bump up your retirement fund. And if President Biden wants to help you along — more power to him!
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