A projected switch in calculating retirement plan benefits from a deduction to a credit could have significant implications for high-net-worth taxpayers, if enacted as initially proposed.
During a recent Senate hearing, Treasury Secretary Janet Yellen announced that she is already looking into changes to current retirement plan rules, and one of the changes many suspect the administration might propose is Biden’s plan, put forward when he was a candidate, to replace the tax deduction for IRA and 401(k) contributions with a tax credit, which could disrupt the way higher earners are saving for retirement.
“President Biden’s plan is an attempt to levelize the retirement plan tax incentives by doing away with dollar-for-dollar tax deductions for retirement account contributions and replacing them with a flat tax credit for each dollar saved,” said Kay Lynn Mayhue, CFP, president of Merit Financial Advisors.
“The proposed tax credit is 26 percent of individual retirement contributions," she added. "Under this plan, someone earning $500,000 would get the same tax break as someone making $50,000 — an identical $260 tax credit per $1,000 of retirement contribution. The credit would also be refundable, so someone earning too little for the credit to fully offset their income tax liability would still get the full tax credit."
As an example, Mayhue posited a high-earning individual under the age of 50 in the 32 percent income tax bracket. If they contribute the current 401(k) maximum of $19,500, they would receive a tax credit of $5,070 (26 percent of $19,500) and effectively pay $1,170 more in tax ($6,240-$5,070).
“This is nearly a 20 percent reduction in tax savings,” she said
Conversely, Mayhue said, if an individual making $50,000 in the 12 percent tax bracket contributes $7,500, or 15 percent of their pay, they would save $900 in tax under current law, while under Biden’s plan they would receive a tax credit of $1,950 (26 percent of $7,500) and effectively pay $1,050 less in tax ($1,950-$900).
“This more than doubles the potential tax savings,” Mayhue concluded.
Strategies for high earners
High earners paying an income tax rate over 26 percent in effect would see the tax benefits of contributing to pre-tax retirement plans reduced, observed Mayhue: “They may decide they would prefer to contribute directly to a Roth 401(k) for the future tax benefits in the form of tax-free growth and withdrawals. This may be even more attractive for clients approaching retirement if they feel income tax rates in general will be increased as they transition to retirement.”
A “mega-backdoor Roth” is another option, Mayhue suggested: “If the retirement plan allows, an employee under 50 can make contributions to an after-tax 401(k) account. An employee under 50 can have total contributions of $58,000 to pre-tax and after-tax 401(k) accounts, including employer contribution,” she said.
“In this scenario, an individual could make maximum contributions to an after-tax 401(k) account and then convert to either an in-house Roth 401(k) plan, if one exists, or to a traditional IRA and then a Roth IRA — the ‘Backdoor Roth’ strategy," Mayhue added. "For this to work, the individual’s 401(k) plan must offer in-service withdrawals to convert the after-tax 401(k) to an IRA or Roth IRA.”
“Of course, these examples are hypothetical, and depend on potential changes going into effect in the way the plan was initially proposed,” Mayhue emphasized.
