Biden calls for an overhaul of 401(k) tax breaks. What it means for you

A change to the tax incentives for saving in a retirement plan might be in store if Democratic candidate Joe Biden wins the election.

In his recently unveiled tax plan, the former vice president called for “equalizing the tax benefits of retirement plans.”

“Current tax benefits for retirement savings provide upper-income families with a significant tax break, while providing a limited benefit for low- and middle-income workers,” Biden noted on his website.

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By equalizing benefits across the income scale — a move that could give savers a tax credit valued at up to 26%, policy analysts said – working families would receive an incentive for stashing money away in retirement plans.

Depending on how it’s structured, lower-income workers might not only be encouraged to save more money, they might also reap more tax savings when they file their returns, analysts said.

“Higher-income people get a bigger benefit from deductions,” said Eric Toder, co-director at the Urban-Brookings Tax Policy Center. “Instead of a deduction, you get back a credit — no matter your income or your tax bracket, you get the money back even if you pay no income tax.”

Here’s how it might work for you.

When you contribute to a 401(k) plan at work, you do it on a pretax basis — the money comes out before income taxes and other levies are applied to your pay.

Your retirement plan contributions help lower your taxable income.

The magnitude of this savings will vary based on your tax bracket. The higher the bracket, the more you save on taxes.

For instance, let’s say you’re making $100,000, and you’re single, which means you’re in the 24% tax bracket. If you commit to putting away $10,000 a year – 10% of your pay — into your 401(k), you’re reaping about $2,400 in tax savings.

In comparison, a single filer making $40,000 and saving 10% of his pay — $4,000 – into a 401(k) would only reap about $480 in tax savings. That’s because he’s in the 12% tax bracket.

To equally incentivize savers regardless of what they earn, Biden proposes a credit of approximately 26% to replace the deduction savers get for putting money in a 401(k) plan, according to the Tax Policy Center’s analysis.

“The biggest thing that stands out to me, by contrast to other proposals, is that it limits the benefit for the highest earners and gives the benefit to the lowest earners,” said Jeffrey Levine, CPA and director of advanced planning at Buckingham Wealth Partners in Long Island, New York.

“It’s a true redistribution of wealth proposal,” he said.

Going back to the above example, the high-income taxpayer who’s contributing $10,000 a year would get a credit of $2,600. That’s compared to a deduction of $2,400 under the current framework.

Meanwhile, the low-income worker saving $4,000 a year would get a credit of $1,040. He would’ve had a $480 deduction under the current system.

“The contribution you make would be included in your income instead of deducted, but you’d get a credit to reduce the amount of liability,” said Alicia Munnell, director of the Center for Retirement Research at Boston College.  

“The credit is the same for people across the spectrum; you get it when you pay your taxes.”

Details on how the credit would ultimately shape up for savers are still scanty.

If it were a refundable tax credit — that is, you get a tax refund even if the credit exceeds the amount you owe — it could be an even more effective perk for low-income savers, said Dan Herron, CPA and principal of Elemental Wealth Advisors in San Luis Obispo, California.

Nonrefundable credits, meanwhile, only give you a refund up to the amount you owe. They don’t increase your refund at tax time.

“If it’s refundable, it’s an extra push for the less fortunate,” he said. “It’s a fantastic way to get money back into people’s pockets.”

Meanwhile, higher-income earners who currently enjoy greater tax savings from contributing to a 401(k) might be more inclined to save in Roth accounts, experts said.

That’s because if the contributions themselves are already going to be included in income, it might make sense to shift the savings over to a Roth 401(k) plan or a Roth individual retirement account.

Those accounts allow you to sock away after-tax dollars and have them grow tax-free. You can tap the money in retirement free of taxes.

“They’re not necessarily taking away the benefit but reducing it for higher income savers,” said Jamie Hopkins, director of retirement research at Carson Group.

“You can make a stronger argument today that they should look at the Roth.”

For households whose income is so high they can’t contribute to a Roth IRA — they are single with a modified adjusted gross income of $139,000 ($206,000 if married and filing jointly) — a backdoor Roth contribution might make better sense, said Herron.

In this case, a saver would make a nondeductible contribution with after-tax dollars to a traditional IRA account and convert it to a Roth. This conversion would be free of income taxes in most cases.

“I would think you’d see more backdoor Roth IRAs,” he said. “You see a lot of that in the high-income earner realm.”