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A little over two weeks ago, Joe Biden was projected by every major media outlet to become the 46th president of the United States. Predictably, the current occupant of the White House and his supporters took it super well, taking to the airwaves to claim he won the election and challenging the results in court, alleging massive voter fraud.
All of that sound and fury, however, has so far resulted in nothing. Over thirty lawsuits filed by the Trump administration have been thrown out because they have not shown any evidence of voter fraud affecting enough votes to sway the election. Trump has refused to concede, but as multiple election experts confirm, the incumbent conceding is not required for the election winner to take office. Legally, Biden becomes president on January 20th. The only choice Trump has in the matter is whether he leaves on his own power or is dragged out by his ankles by Secret Service.
So barring some unpredictable black swan event between now and January, it looks like Joe Biden will be sworn in as president.
I wrote in the last article about some of the effects a Joe Biden presidency would have on the FIRE community. Amusingly, the comments section devolved into a food fight, but the gist of it was that unless you were earning above $400k in your day job, you were unlikely to have your taxes materially affected, and might even see your post-FIRE health care options improve.
One of the more curious aspects of his tax plan that I immediately zeroed in on is his proposed changes to the 401(k) (and Traditional IRA) plan, which immediately perked my ears up since a fully funded 401(k) is something we recommend for everyone trying to get to FIRE. Specifically, his proposal eliminates the tax deductability of 401(k) contributions, instead replacing it with a 26% refundable tax credit.
Now what the Hell does that mean?!?
Deductions vs. Credits
When you make a contribution to a 401(k) plan, you’re doing it with pre-tax dollars. Those contributions can be subtracted off your taxable income, which has the effect of reducing your tax bill. This means that the benefit of making that contribution is equal to your marginal tax rate, or the incremental tax rate you pay on the last dollar you earned.
If we were to look at the federal tax brackets for 2020, if a single earner makes $200k a year, they would be in the 32% tax bracket. So if that person makes a $10,000 401(k) contribution, they would get a check from the federal government equal to $10,000 x 32% = $3,200.
If another single earner made $20k a year, they would be in the 12% federal tax bracket. If that person made a $10k 401(k) contribuion, they would get a refund equal to $10,000 x 12% = $1,200.
Clearly, the benefit from making a 401(k) contribution is not equal, and depends on how much you make. If you make more, you get more money from making 401(k) contributions, and if you make less, you benefit less. If we were to plot the tax refund you’d get from making a $10k contribution and compare it to your earnings, the chart would look like this.
Joe Biden’s proposal is to turn this into a flat tax credit. Rather than deducting the contribution on your income, you’d simply get a credit on your tax return equal to 26% of your contribution.
This makes the tax benefit of making a 401(k) contribution no longer dependent on your income. This is what Joe Biden’s campaign meant when it refered to “equalizing the tax benefits or retirement plans.” The person earning $20k a year would get the same refund as the person earning $200k a year.
If we were to add this new proposal to the chart above, it would look like this.
What Are The Effects Of This Change?
As you can see in the above chart, the two lines intersect at the $163k level. What this tells you is that this policy splits taxpayers into two groups: Those earning below $163k (as a single filer) and those earning more.
For those in the first group, your benefit from making a 401(k) contribution will go up. In the $84k to $163k earnings bracket, the benefit will be relatively little (24% to 26%), but it becomes dramatic at lower income levels, potentially jumping from 10% all the way up to 26%.
And for those in the second group, your benefit will go down, with the people in the highest earnings bracket of $510k+ seeing the biggest decline from 36% all the way down to 26%.
As for the federal government, they won’t notice on balance. They’ll hand out smaller refunds to the $163k+ crowd, but hand our bigger ones to the $163k and below crowd. The policy was designed to be revenue-neutral for the government, with the 26% level chosen so that the change in refunds from one group balancing out the other.
Why Would The Government Make This Change?
There’s a few different ways to understand the rationale behind this policy change. One is the more “social justice warrior” school of thought, which states that because 401(k) plans benefit higher earners the most, a 401(k) plan is therefore a tool of inequality an should be changed to benefit everyone equally. I don’t really like this way of looking at it, because it can be seen as “punishing” higher earners by taking away some of their tax breaks. Whenever you start punishing success, all sorts of unintended bad things happen, like professionals deliberately working less hours to pay less taxes.
Another way to look at it is that the Joe Biden government wants to encourage more people, especially at the lower end of the earnings spectrum, to save for their retirements. I think that’s an admirable goal. It’s just that they also wanted to do it in a revenue-neutral way, which unfortunately means handing out more refund checks to some people will need to be offset by smaller refunds in others.
Should People Change How They Save?
Depending on how much you earn, yes.
Under the current system, if your earnings are in the 10% to 12% level, it really doesn’t make much sense to contribute much to your 401(k). The refund you’d get out of it just isn’t that much, plus you’d have to worry about the tax rate you’d pay when you take it back out. If the tax rate at withdrawal is about the same as the tax rate on contribution, then you really don’t get much benefit, and in those cases it made sense to contribute to a Roth IRA instead.
Under this new system, it makes much more sense to fund your 401(k) before your Roth IRA.
For higher earners, however, the reverse isn’t true. Just because your benefit is less for 401(k) contributions doesn’t mean you shouldn’t make them. A 26% credit is still better than 0%, so this change shouldn’t incentivize you to skip making contributions each year.
Nor does it make sense to shift your 401(k) contributions towards your Roth IRA. Remember that even though withdrawing from a 401(k) is taxable while withdrawing from a Roth is not, because you’re still getting a 26% credit with you contribute, as long as you’re paying less than 26% tax when you withdraw, you still come out ahead with the 401(k). And paying 26% tax on withdrawal would require you to be making more than $163k in passive income in retirement, and that would only happen if your projected retirement portfolio is in the $4 million+ range.
That being said, we’re not saying to ignore the Roth. While it’s difficult to come up with a scenario in which contributing to a Roth instead of a 401(k) makes financial sense under this system, the real goal for everyone reading this who’s still in the accumulation phase of their FIRE journey is to max both out.
But whereas before when the advice was to prioritize the Roth at lower earning brackets, now under the new system the advice is:
- Fill up your 401(k) to the max
- Then fill up your Roth IRA to the max, possibly using Backdoor Roth IRA contributions if you earn too much.
So that’s the Joe Biden presidency’s proposed changes to the 401(k) plan. There are still some details to be ironed out, and remember that a proposal doesn’t necessarily mean it’ll become law (after all, we still don’t know which party will control the Senate), so it’s entirely possible that what gets implemented looks very different from what I’ve just described, but on a whole, I think it encourages more people to save for retirement, which is a Very Good Thing.
What do you think? Do you think these policy changes are a step in the right direction? Or is this just Exhibit A in the Democratic party’s insidious slide into Socialism? Let’s hear it in the comments below!
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