Joe Biden and Kamala Harris have a proposal for retirement accounts that could change the way many people save for retirement. The intent of this proposal is to increase retirement savings for lower- and middle-income taxpayers by replacing the tax deductibility of a 401(k) or IRA contribution with a tax credit. Here is how the proposal would likely work.
Under current law, taxpayers can claim a tax deduction for their contributions to 401(k) and traditional IRA accounts. Because tax-deductible contributions reduce taxable income, the tax savings depend on the person’s marginal tax rate. This means that people who earn more and pay a higher marginal rate receive a bigger benefit than those with lower taxable income. For example, a contribution of $1,000 would save someone in the 35% bracket $350 in taxes, while that same contribution would reduce the tax bill of someone in the 12% bracket only by $120.
Under Biden’s proposal, contributions would no longer be deductible. Instead, everyone would get a flat 26% tax credit for their contributions. A tax credit reduces a taxpayer’s tax liability dollar-for-dollar and the value of a tax credit does not depend on the taxpayer’s marginal tax rate.
This means that a contribution of $1,000 would save everyone $260 in taxes, regardless of income. A taxpayer in the 35% bracket would pay $90 more in tax for every $1,000 contribution, while someone in the 12% bracket would save an additional $140 in taxes.
Many of the other details are unclear at this time, but it looks like the tax credit would be either refundable or would be deposited into a taxpayer’s retirement account as a matching contribution. (A refundable credit means that a person can receive a cash refund if the amount of the credit exceeds the tax owed on the tax return). Also, the Biden proposal does not change the taxability of distributions from 401(k)s and traditional IRAs.
One impact of this proposal if it were to become law would be to make Roth and other after-tax retirement account options more attractive for higher earners, while making traditional IRA contributions more attractive to those in lower tax brackets.
This proposal is a long way from becoming law even if Biden were to be elected, but it is an interesting and significant proposal that is worth keeping an eye on. We will keep you informed regarding any new developments.