A Refresher Course On 401(k) and IRA Taxation – For Joe Biden’s Advisors, Too

Let’s start from scratch: what are the tax advantages of a traditional or Roth 401(k) or IRA?

In both cases, they allow savers to avoid paying taxes on their investment returns.

In the case of a traditional IRA/401(k), they also allow savers to pay their taxes, ultimately, based on their total effective tax rate during their retirement, rather than their marginal tax rate at the time of their contribution.

In the case of a Roth account, they allow savers to “lock in” their current marginal tax rate. Savers who expect their tax rate to be higher in retirement because their current income is low only temporarily, or because they have many deductions (e.g., many children!), or even because they believe that income tax rates will increase across-the-board in the future, will find a Roth to be more attractive.

There are also some differences in terms of income limits and contribution restrictions but that’s neither here nor there, as far as taxation is concerned.

Now, in my prior “actuary-splainer”, I had emphasized the first of these elements, and, in particular, the math behind it, and I’ll restate it again due to confusion in the comments/feedback I received:

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Contribution x Reduction Factor for Taxes x Increase Factor for Investment Returns

is the same as

Contribution x Increase Factor for Investment Returns x Reduction Factor for Taxes

by basic mathematical principles.

And this means that the “tax savings” is not the deduction a saver receives when first contributing the money to the account. If a saver has a tax rate of 30%, he or she doesn’t “save” 30% because those taxes will be paid later. There’s not even a convenient way to quantify the tax savings because it’s a matter of removing the extra taxes that would be paid on investment earnings, and it depends on the tax rates on investment earnings and the level of investment earnings over time. (I’ll refer you again to my prior explainer.) In the same way, there’s no single number to quantify the savings due to paying taxes on post-retirement total income instead of pre-retirement marginal rates, but this is also not a matter of “saving 30%.”

Also, to add another actuarial concept: does the government “lose” money by allowing 401(k) savers to defer paying taxes until retirement? To answer that question requires making an assumption: what discount rate (actuary-speak for interest rate) do you use for the math to calculate the “present value” of the future tax payment? If you calculate based on the same rate as for investment returns, the two amounts are the same. If you calculate based on a lower rate, like the current very low government bond rates, the future deferred taxes of a traditional 401(k) are worth more to the government, as a present value, and cost more for the taxpayer, than in a Roth account.

Which all brings us back to the Biden team’s proposal for replacing the 401(k) tax deduction with a credit.

In my original August 25 article, I relied on the Biden campaign website, a Roll Call article in which a member of the campaign staff discussed the plan, past proposals by think tanks/experts, and my own knowledge and experience. On August 26, a staff member at the Tax Foundation, Garrett Watson, wrote with more confidence (whether because of confirmation from the Biden team, he doesn’t say) about the proposal:

“Biden proposes converting the current deductibility of traditional retirement contributions into matching refundabletax credits for 401(k)s, individual retirement accounts (IRAs), and other types of traditional retirement vehicles, such as SIMPLE accounts. Biden’s proposal would eliminate deductible traditional contributions and instead provide a 26 percent refundable tax credit for each $1 contributed. The tax credit would be deposited into the taxpayer’s retirement account as a matching contribution. Existing contribution limits would remain, and Roth-style tax treatment would be unaffected.”

He further links to an AARP proposal from 2012, which includes the same provisions, but also specifies that “withdrawals from the accounts would continue to be taxed as ordinary income.”

Losing the ability to use pre-tax money to make contributions in exchange for a tax credit seems reasonable enough, but maintaining the 401(k) rules of taxing everything as ordinary income, then becomes double-taxation, to the extent that the initial taxation is greater than the credit received. Perhaps, more generously, the authors and explainers of these proposals really intend for these accounts to be taxed in the entirely ordinary way that a non-retirement mutual fund is, where only the investment earnings are taxed.

But once again, as with other similar explanations, Watson says, “a taxpayer in the top marginal tax bracket receives a $37 tax benefit for every $100 contributed into a retirement account, while a taxpayer in the bottom bracket would only get a $10 tax benefit for the same $100 contribution.”

And, once again, we know that this is wrong. A taxpayer in the top tax bracket receives a tax benefit equal to the savings in not paying taxes on investment returns, and in being able to pay taxes, eventually, at total effective rather than marginal tax rates.

Watson doesn’t seem to understand this. The AARP proposal doesn’t seem to. It is possible that the individual who calculated that a 26% credit would be revenue-neutral did indeed understand this (the Tax Policy Center calculations do recognize that the expenditures change over time, but don’t model the costs past 2040 so as to properly impact the impact of workers’ tax-paying on distributions in retirement) but still unclear. And if the individual who originally calculated that 26% figure didn’t get the math right, which I suspect is the case because that number just doesn’t look right, then the actual legislation will end up increasing federal spending or disappointing many supporters.

Which means — well, readers, I hope you understand 401(k) taxation a little better.

The question is, does Joe Biden’s team?

As always, you’re invited to comment at JaneTheActuary.com!

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