Benjamin Franklin is often quoted for his statement, “Nothing can be said to be certain, except death and taxes.” What Ben Franklin did not expound on, however, was that just because taxes are certain, does not mean that they are not everchanging and will not present plenty of uncertainty. Our country’s tax system is a key component in how society achieves both social and economic objectives; changes in tax policy can have profound effects on the behavior of individuals and corporations.

With every presidential campaign comes a litany of proposed tax policy changes. Although these are merely proposals and may never be enacted, it is still a good practice to be aware of what could be coming down the pike. During his 2020 campaign, Joe Biden laid out several tax policy proposals. One of these proposals focused on the deductibility rules for retirement plans which could have a large impact on the way Americans save for their future.

Equalizing retirement plan contributions

Biden’s proposal would equalize the tax benefits of saving for retirement by instituting a refundable tax credit for contributions into a traditional retirement plan such as a 401(k), 403(b), or IRA. Under the current system, contributions to a traditional retirement account are deducted from the individual’s income, effectively providing a tax benefit for the contribution in an amount equal to the filer’s marginal tax rate. Someone in the highest current marginal tax bracket of 37% receives $37 in tax benefit for every $100 contributed to a traditional plan whereas someone in the 10% bracket would receive only $10 in tax benefit for every $100. The new proposal would issue a credit estimated at 26% for every dollar contributed to a traditional retirement plan, so no matter what tax bracket a person falls into, they would receive a $26 benefit for every $100 contributed.

For many, this 26% tax credit will increase the tax benefits of contributing to a traditional retirement plan. This is the intent of the proposed change, with hopes that this higher benefit will incentivize increased retirement savings. There are those, however, that would not benefit from this change in tax code.

Those negatively affected by the proposal

Although the majority of the tax proposal changes that Biden ran on in the 2020 election targeted those with a household income greater than $400,000, this particular proposal could have negative effects on those making less than that amount. For example, someone under the age of 50 who is looking to max out their traditional 401(k) at $19,500 and makes more than $331,470 (using the current marginal tax brackets) would receive a smaller tax benefit than under the current deduction model. The largest amount of tax benefit for maxing out a 401(k) in 2021 would be capped at $5,070 ($19,500 X 26%) for filers under the age of 50 and $6,760 ($26,000 X 26%) for those over 50 who fully utilize catch-up contributions.

In addition to a decrease in tax benefit for individuals over certain incomes, the change from a deduction to a credit can have large implications for many other taxpayers. Funding traditional retirement accounts has historically been a tactic used to lower taxable income. The individuals who use this lever to lower their income would no longer have that option under the proposed change in the tax code.

Lowering taxable income through traditional retirement contributions

Adjusted gross income, modified adjusted gross income, and taxable income are all used when determining eligibility for certain tax benefits and other income-based programs. For example, the amount received in the latest round of stimulus payments is determined by a household’s adjusted gross income (AGI). Single filers over $80,000 will receive no stimulus payment (and a reduced payment for an AGI over $75,000) and those married filing jointly will not receive a stimulus payment for an AGI greater than $160,000 (phasing out beginning at $150,000).

Consider the case of a couple with three children and an estimated AGI of $160,001. They would miss out on the third COVID-19 relief stimulus payment because they are just over the AGI phase-out limit. Currently, the couple can make use of contributions to traditional retirement accounts to realize additional tax deductions and lower their AGI to less than $150,000, qualifying them for the entire $7,000 stimulus payment. Under the discussed proposal, tax strategies such as this would no longer be an option.

Below is a (not inclusive) list of items that are dependent on household income (whether taxable, adjusted gross, or modified adjusted gross):

• Capital gains tax rate
• Child tax credit
• Child and dependent care tax credit
• Adoption tax credit
• Education-related deductions and tax credits
  • American Opportunity Tax Credit
  • Lifetime Learning Credit
  • Tuition and fees deduction
  • Student loan interest deduction
• Itemized deductions
  • Medical and dental expenses
• Health care premium subsidies
• Deductible IRA contributions
• Roth IRA contribution eligibility
• Taxable social security benefits
• Saver’s credit
• Earned income tax credit
• Medicare IRMAA (Income Related Monthly Adjustment Amount)
• Medicare surtax
• Passive activity loss eligibility
• Charitable deductions
• Qualified business income deduction

This proposed tax law change has much wider implications than just affecting the retirement contribution tax benefits received by high income earners.

Planning Implications

If this proposed tax change becomes law, individuals will want to take a look at their personal situation to see if continuing to save in a traditional retirement account is optimal. Rather than contributing to a traditional 401(k), it may become more advantageous for high income earners to make contributions into a Roth 401(k), if available, to take advantage of tax-free compounding and withdrawals. Individuals contributing to traditional accounts solely to lower their income to qualify for certain income-driven benefits would also want to determine if contributing to Roth accounts rather than traditional would be beneficial. These taxpayers can look for other strategies to lower taxable income, such as contributing to an HSA (for those with a high deductible health plan) or a medical or dependent care flexible spending account (FSA).