Art by Joseph CiardielloEvery Presidential candidate has offered up a tax proposal—and every one of those proposals will have significant consequences for 401(k) and 403(b) savings.
Generally, Democratic candidates are proposing an increase in taxes on investment earnings (capital gains and dividends), a cap on “deductions” at 28%; and a steepening of the progressivity of income tax rates—generally increasing taxes on higher income taxpayers. On the Republican side, Mr. Trump would lower rates across the board and eliminate the tax on investment income for joint filers making $100,000 or less. Senator Rubio (R-Florida) would eliminate all individual taxes on investment earnings (taxing all profits at the entity level). Senator Cruz (R-Texas) would go to a flat 10% tax on all income (including investment income) plus what some have called a value added tax.
Before we consider how these proposals would affect the 401(k) and 403(b) tax deal, let’s be clear what that deal is. Defined contribution (DC) plans provide two tax benefits. First, trust earnings aren’t taxed until distributed, so the plan participant “saves” (in effect) the taxes she would otherwise pay on investment earnings outside the plan—taxes on interest, capital gains and dividends. Second, because (non-Roth) contributions aren’t taxed when contributed and are taxed when distributed, taxpayers can move income from a higher-tax rate year to a lower-tax rate year. That’s a benefit to taxpayers with lumpy income or who simply have less income when they retire.
Generally, increases in taxes on investment earnings increase 401(k) and 403(b) tax savings—they increase the value of the deferral of taxation of trust earnings. So as a general matter, the Democrat’s proposals increasing taxes on investment earnings are more “pro-401(k) and pro-403(b).” But if, as President Obama has proposed, the 28% deduction cap they advocate is applied to employee contributions to DC plans, then the value of saving in a DC plan is, for higher earning taxpayers at least, significantly reduced.
Republican proposals to cut the tax on investment earnings would clearly reduce—or, in Senator Rubio’s case, eliminate—this same 401(k) tax benefit.
Do we need retirement savings tax incentives?
All of this raises a fundamental question. If—as seems likely—we are going to spend the next four-to-eight years rearranging the Tax Code, how should retirement savings be treated? The DC plan tax deal has been a significant source of left vs. right controversy, with some Democrats asserting that the current system is fundamentally flawed and unfairly favors the well-off.
I would identify two problems with the current system: it has no coherent rationale; and it lacks all transparency. Those are kind of fundamental issues.
Is a tax preference for retirement savings rational?
I used to believe (following John Stuart Mill) that an income tax system “unfairly” taxes interest on savings. Interest, and dividends and capital gains—that is, investment income—are simply compensation for the deferral of consumption. Because of our natural bias towards consuming today, those who defer consumption (in return for interest, etc.) are simply being compensated for the reduced value of their future consumption.
If you take that view, then, in an income tax system, you need something like the 401(k) tax exclusion, to avoid penalizing people for saving.
The last eight years, resulting in a situation in which some banks are now charging negative interest, have convinced me that that view is wrong. Savings is just another financial transaction, in which market participants (savers and borrowers) trade time preferences. Thus, a tax break for savings is not a necessary part of an income tax system.That said, there may be a bias in human nature against savings—I believe it’s reasonable to assume that many (most?) of us are grasshoppers rather than ants. We probably do need incentives of some sort—defaults or even mandates—to save for retirement. Social Security is certainly such a mandatory system. It’s not clear to me, however, that the Tax Code—given the intensity of left-right divisions over tax policy—is the best place to implement those incentives.
A tax policy mess
Moreover, our current system is hopelessly opaque. While you would think that most of the (explicit) benefits of the DC plan tax exclusion would go to high-earner, high-margin taxpayers, because of our flat tax on investment earnings, they actually don’t. The low-paid employee contributing to a 401(k) or 403(b) plan is saving the same 15% capital gains tax that the high-paid employee is. There are only three exceptions: taxpayers in the top bracket pay a 20% capital gains/dividends tax; taxpayers with adjusted gross income (AGI) more than $200,000 (single)/$250,000 (joint) pay a 3.8% Medicare net investment income tax; and interest is taxed at ordinary income tax rates.
401(k) plans also allow a certain amount of income shifting, but it is unclear how much of that there is and how it should be analyzed. Is the taxpayer who makes a contribution when she is in the 39.6% bracket and then takes a distribution when she is in the 15% bracket high-paid or low-paid?
To this confused tax policy situation is added the implicit benefit of the Tax Code nondiscrimination rules, which in effect require that, in return for the tax benefits high-paid employees are getting, low-paid employees must be provided with a comparable benefit. What those low paid benefits are worth and who is actually paying them (employers? high-paid employees? other taxpayers?) is hopelessly obscure.
* * *
Given these problems with the current system, my vote is to take retirement savings tax incentives out of the Tax Code. What do we replace it with? How should we incentivize retirement savings? Good questions. I would like to see a robust, and hopefully transparent, debate about them.
Michael Barry is president of the Plan Advisory Services Group, a consulting group that helps financial services corporations with the regulatory issues facing their plan sponsor clients. He has 40 years’ experience in the benefits field, in law and consulting firms, and blogs regularly http://moneyvstime.com/ about retirement plan and policy issues.This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Asset International or its affiliates.