With the presidential election upon us, many people are focused on what each of the candidates say they will do if they win. In financial circles, one of the things that has drawn interest is Joe Biden’s plan to rework the tax break connected with contributing to a traditional 401(k) plan. What could Biden’s tax plan mean for your clients?
The Current Tax Break
Currently contributions to a traditional 401(k) account are made with pre-tax dollars. This provides a tax break in that the value of your client’s contributions are excluded from their taxable income. While all employees who contribute derive at least some tax benefit from making pre-tax contributions, this benefit is skewed toward higher-income taxpayers. Based on our current tax rates, clients in the highest tax bracket, 37%, who contribute the full $19,500 to their 401(k) in 2020 would receive a tax benefit of $7,215. Someone in the 22% tax bracket would receive a tax break of $4,290, while someone in the 12% tax bracket who contributed the full amount would only receive a $2,340 tax break.
Biden’s plan takes a different approach to the take break for contributions. Under Biden’s plan, workers contributing to a traditional 401(k) account would receive a tax credit as a percentage of the amount contributed. The maximum credit amount would be 26% of the contribution amount. In the example above, someone contributing the full $19,500 would conceivably receive a tax credit of $5,070. This credit would be income-agnostic so to speak, in that everyone would receive the same credit amount regardless of their income.
As you of course know, a credit is a direct reduction in the amount of income tax due, versus a reduction in taxable income which is how the current pre-tax contributions work. While this is still valuable, it may be less valuable to those at higher income levels.
If indeed this does come to fruition, you will need to look at how this impacts each individual client tax-wise. It’s important to remember that even if the upfront tax benefit is reduced, the money contributed would still grow on a tax-deferred basis until your client withdraws it in retirement.
Some experts feel that if Biden is elected and if he pushes forward with this plan for 401(k)s, this might propel interest in making contributions to Roth 401(k) accounts versus traditional accounts for higher income taxpayers. The thought here is with a reduced upfront benefit, it may make sense to contribute on an after-tax basis in exchange for the opportunity to make withdrawals tax-free in retirement.
Another factor that may sway this decision in one direction or the other is where tax rates head in the future under a Biden administration. This factor, along with the potential implementation of the tax credit for traditional 401(k)s could have a potential impact on your clients who contribute to 401(k) plans at work.
Impact on Small Business Retirement Plans
Some people in the industry feel that this change may also impact whether or not small business owners continue to offer 401(k) plans for themselves and for their employees. With the reduced tax breaks for contributing to the plan, the thought is that many of these small business owners might feel that the cost of offering the plan isn’t worth it. This may be a conversation that comes up with some of your clients.
The move from the ability to make pre-tax contributions to receiving a tax credit will impact these clients on a personal basis, but this change may not negate the other benefits of offering these plans both for themselves and their employees. Again if this does come to pass, this will be a conversation that is needed with each client in this situation with your recommendations tailored to their overall unique situation.
While at this point in time there is of course nothing that you should be doing. If these or perhaps other changes come to pass in the 401(k) space your clients will look to you for guidance. Be sure to encourage them to look at any changes in a holistic fashion, not just based on changes to the tax treatment of contributions.