President-Elect Joe Biden has proposed a 401(k) flat tax credit that may make you rethink how you save for retirement.
While nothing has been officially passed yet, many people are wondering how his overhaul of 401(k) tax breaks will impact them personally if and when it becomes a reality.
As someone who is currently saving for retirement, it is important to understand how Biden’s proposed tax credit differs from current tax incentives and how it will change the way you save for retirement going forward.
Saving for retirement today
Today, when you save for retirement, you use tax-deferred accounts like 401(k)s and IRAs. Your contributions receive a tax deduction (or come out of your paycheck as pre-tax deductions from your income directly), and your money is able to grow on a tax-deferred basis until you begin withdrawing funds in retirement. Once this happens, any withdrawals are counted as taxable income in whatever tax-filing year the withdrawals are made.
Higher-income earners stand to receive a greater tax benefit when they contribute to these tax-deferred accounts because it helps to reduce their taxable income and this income might have otherwise been taxed at rates as high as 35% or 37%. Lower-income earners may only be receiving deductions on income that would have been taxed at rates such as 10%, 12%, or 22%.
The government incentives citizens to save for retirement, but the tax benefit isn’t necessarily the same when you have less income. Lower-income earners are likely deferring income they would have otherwise paid taxes on at much lower rates.
The controlling idea behind Biden’s tax proposal
Biden’s proposed 401(k) tax credit potentially levels the playing field for all savers, regardless of income. Here is what you need to be aware of so that you know what to expect as you save for retirement in 2021.
Under Biden’s tax plan, there will be more tax incentives for lower and middle-income households to save into pre-tax 401(k) plans.
Tax benefits will be equalized across income levels.
High-income households won’t get as much of a tax benefit from contributing to a traditional 401(k) plan.
Based on the proposal, one flat rate would be developed and this rate would be based upon the average tax-savings across all taxpayers from the preceding tax year. According to most analysts, this number would fall at about 26%.
How Biden’s 401(k) tax credit proposal flips the table for savers at different income levels
Biden’s 401(k) flat tax credit proposal may flip tax planning on its head - literally.
High-income households used to getting deductions on money that would have otherwise been taxed at 35% may now only receive somewhere around a 26% credit. In this case, high-income households may be better off making contributions to a Roth 401(k) plan instead of a traditional 401(k) plan.
Conversely, lower-income households who have been advised to make Roth contributions because they aren’t getting a large enough tax incentive under the current rules may now get a much larger credit for their traditional 401(k) contributions. Meaning, saving in a tax-deferred vehicle like a Traditional 401(k) instead of a Roth 401(k) may provide more tax benefit.
What it means for people saving for retirement
Tax planning has always been an important element of overall financial planning and saving for retirement. Tax planning is especially critical when changes occur like Biden’s proposed 401(k) tax credit or Trump’s Tax Cuts and Jobs Act of 2017.
Changes to the tax laws and incentives create a tax planning opportunity so that you can derive the greatest tax benefit for your personal situation.
In the case of Biden’s proposed tax credit, it is still a proposal and not yet law. Although, it is highly likely that something will get passed some time in 2021. Therefore, while we wait to see what the final proposal is and what actually gets passed by Congress, you can consider reducing the percentage you save into your retirement accounts for the first half of 2021. Then, increase contributions later in the year, either into your Roth or traditional 401(k) once you know which retirement savings vehicle will provide the greatest benefit to you under Biden’s new plan.
Make tax planning a priority in 2021
Be sure to make tax planning a priority for your family this year. Evaluate your overall tax situation so that you are in a position to make a decision on the best tax strategy for your family based on your individual income situation.
Having a tax strategy for your dollars means that you never pay more taxes than you’re legally obligated to and can keep more of your money for yourself and your future. Every detail matters from how a flax tax credit can impact your ability to save more to how higher taxes in the future will affect your income in retirement. These considerations and the decisions you make because of them are just as important as how you invest.