A little-noticed feature of Democratic presidential nominee Joe Biden’s tax plan would flip the incentive structure of a retirement system grounded for nearly a century on the tax deductibility of saving.
The former vice president’s "drastic" proposal, in the words of one industry lobbyist, would upend existing tax preferences for retirement saving in 401(k)-style plans. The Investment Company Institute, which represents mutual funds, exchange-traded funds and other investment vehicles in the U.S. and abroad, has already promised opposition.
Under current law, workers contribute pretax dollars and thereby reduce their annual taxable income, but they pay full freight when funds are eventually withdrawn in retirement. The upfront tax break is larger for richer households, however, since deductions are more valuable the higher one’s tax bracket is.
For example, take a single filer in the top 37 percent bracket making $600,000; for each $1,000 she contributes to a 401(k) plan, her tax deduction is worth $370. A single filer earning $60,000, however, would be in the 22 percent bracket and only receive a $220 tax break for that same $1,000 contribution.
What’s more, upper-income earners tend to save more in 401(k) plans, which have an annual cap that rises with inflation; in 2020, the limit is $19,500, with an extra “catch-up” contribution of $6,500 allowed for those 50 or older. The more pretax dollars set aside, the larger the tax break is.
Workers can also save $6,000 in 2020 in traditional individual retirement accounts, or $7,000 for those 50 or older. Such contributions are fully deductible unless one or both spouses also have a workplace retirement plan, in which case the deduction phases out for higher earners.
Biden would instead “equalize” the incentive system by ending such deductions and replacing them with flat tax credits for each dollar saved. The campaign isn’t saying what that percentage would be, but the Urban-Brookings Tax Policy Center has estimated a 26 percent credit would be roughly revenue neutral over the first 20 years and beyond, which the Biden campaign is aiming for.
Under this plan, someone earning $600,000 would get the same tax break as someone making $60,000 — an identical $260 tax credit for their $1,000 retirement contribution. The credit would also be refundable, so someone earning too little for the credit to fully offset their income tax liability would still get the full tax credit.
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.
Fewer reasons to save?
Industry groups that represent workplace savings plan providers, mutual funds and other investment asset managers traditionally resist big changes to the current system since it could depress interest in big-dollar savings accounts. It’s not clear how much more lower-income earners would actually save overall, despite bigger tax incentives, while richer households might save less in traditional retirement plans, critics say.
“Before any changes are made I think that there needs to be some studies done as to what the behavioral impacts would be in making a drastic change to a system that’s been in place for so many years,” said Paul Richman, chief government and political affairs officer at the Insured Retirement Institute. IRI represents insurers, distributors, banks and asset managers, all of whom have a stake in the retirement savings plan ecosystem.
“We think it’s totally appropriate to have a conversation about how to help people save more money and enhance their financial security,” added Armstrong Robinson, senior vice president for government affairs at the Association for Advanced Life Underwriting and GAMA International, another insurers’ group that represents 401(k) plan managers. “I’m not sure we would be as enthusiastic if the proposal is to limit what others can responsibly save for their own financial security.”
In 2017, it was industry opposition — and a well-timed tweet from President Donald Trump — that stopped a House GOP proposal to include a revenue-raiser in their initial tax overhaul plan that would sharply curtail retirement plan tax deferrals.
House Republicans had floated a plan to limit 401(k) plan deferrals to $2,400 annually, with any excess savings directed into Roth-style after-tax accounts in which contributions are taxed upfront but gains built up over decades could be withdrawn tax-free in retirement.
Both Trump and Democrats derided the plan as a tax increase on middle-class savers, while industry groups went to work against it, and it was left out of the initial House bill and final tax law (PL 115-97). A 2017 survey by LPL Financial, a large broker-dealer and investment advisory firm, found that only about 27 percent of small-business retirement plans they managed would be maintained in their current form.
The Investment Company Institute, which opposed the House GOP "Rothification" proposal in 2017, says it will fight efforts to replace the current tax structure with a flat refundable credit.
“ICI supports tax deferral and the current, voluntary employer provided retirement system, and, as in the past, will oppose changes that undermine the success of this system,” the group said in a statement.
Another bite at the apple
The Tax Policy Center’s Bill Gale, who pitched a similar plan to the Senate Finance Committee in 2011, says Democratic wins in November may mean the time is finally ripe for such a "drastic" change. "We don’t get that many bites at the apple," he said.
Gale said Biden’s adviser, Harris, worked for him at Brookings around the time the plan was being developed. “It’s not a total coincidence that he’s talking about this proposal,” Gale said.
Progressives have long complained that deductibility is an “upside-down” incentive that favors the rich, while tax credits, as long as they are fully refundable, are far more accessible. But 2012 was the last time anyone ran the numbers on how such a plan would impact different income groups, Gale and others say.
In 2012, the TPC estimated that replacing the tax deductibility system with a 30 percent tax credit would be revenue neutral. But the tax benefits would be enjoyed overwhelmingly by the bottom 90 percent of households based on income, with tax increases falling disproportionately on the top 10 percent of earners, Gale said.
The general conclusion that a tax credit would make the system more progressive, bringing gains to middle- and low-income earners and losses to the wealthy, is “going to hold,” Gale said. But since the tax code and economic conditions have changed substantially since 2012, Gale said it’s “going to be hopelessly complicated to get a precise, new estimate.”
Gale argues that the wealthy would save roughly the same amounts with or without the tax break. Roth plans might become more attractive to upper-income households, while traditional defined benefit pension plans, which would retain their current tax-favored status, might return to prominence.
But industry opposition is to be expected, Gale said.
“The retirement industry in my view has been a significant obstacle to useful reform,” he said. “There’s a variety of proposals that they don’t like because they don’t want to have small accounts … but at the same time they don’t want anyone else to have those small accounts because they can grow into large accounts.”