Transcription: Segment 1
Paul Winkler: And welcome to the Investor Coaching Show. Paul Winkler, talking about the world of money and investing and all that good money stuff, Jim Wood here with me. I feel a need to revisit something from last week because of the firestorm created by it. And you know what that is, people are wondering about the Biden tax written proposal.
Stock markets go up more than they go down. They go up, regardless of whether there’s a Democrat or a Republican in the White House. They go up regardless whether it’s Democrats or Republicans running the Senate or running the House in Congress. And you know, I just try to stay out of it just for that particular reason.
The purpose of 401(k)s
And I don’t know what it is, but you can’t please everybody all the time. And Lord knows that I’m not gonna even try, but there was a thing that we were talking about and I want to just run through this. And it was a proposal by Biden on, in regards to 401(k) plans that I spent some time on last week. And I think I got some people a little bit confused and I was a little bit confused because when we started reading the article on it, there was some information in there that was just not terribly clear.
And I didn’t like the article necessarily, but it was the most popular. It was the only one out there that I saw talking about the Biden tax proposal regarding 401(k) plans. And what we are going to do is spend a little bit of time. So this is where the numbers come from, and this is how it works out. So in essence, on a 401(k), what happens when you make a contribution to a 401(k) plan, as it stands right now, you get a deduction on your taxes.
The idea with 401(k)s is that employers will set up the plan because the employer—being the business owner—is usually in a high tax bracket. They pay taxes at a much higher rate than the rank and file employee, of course, since they’re getting a greater share of the business income, because, well, it’s their business.
We’ll just focus on federal taxes because with state taxes it gets even worse, especially if you live in California. Jim, you miss California?
Jim Wood: I miss the weather.
Paul: He used to live in California. He’s one of those people that came here because well, California, the tax rates are so high, cost of property taxes and income taxes and the cost of property itself. And just the cost of living itself out there is just outrageous. And there was the opportunity to come out and work with such wonderful people. There you go. And I paid him for that. So if you’re dealing with a state income tax, now you have a whole other level of taxation, but I just want to deal with federal income taxes right here.
So, 401(k)s are first and foremost set up to give a tax break on investing for retirement, and they can be particularly beneficial to the owners and executives of the company because their tax rates are often higher.
The tax benefits of a 401(k)
You get to invest money into a 401(k) tax free. The money you put into the 401(k) account avoids your tax rate. So the higher your tax bracket, the bigger the advantage.
If you make a contribution to a 401(k) plan, and you’re one of those high income people, the tax rate for the highest income earners in America right now is 37%. So if I make a thousand dollar contribution to a 401(k) plan, I get a $370 tax reduction. So the whole thousand dollars goes to work. And $370 that would have gone to the federal government now gets to earn income for me.
Now, if I’m in the absolute lowest tax rate, I get a $100 tax deduction, because the lowest tax rate is 10%. Then rates go up to 12%, 22%, 24%. And it goes on up until you hit 37%. So with a traditional 401(k) plan, you get a tax break equivalent to whatever your income tax rate is.
Now there are also Roth 401(k)s and Roth IRAs and a company can set up a 401k and they can decide to have Roth provisions. If they do, you don’t get a tax deduction for contributions where you put after tax dollars in it. So if you’re in that 37% tax bracket and you put a thousand dollars away into your Roth 401(k), you don’t get a tax deduction. So you take the 37%, $370. You take that off of your thousand dollar investment, and you only get to invest the $630 that’s leftover.
That is what goes into the Roth 401(k). So you got $1,000 minus the 37% tax is $370, which leaves $630. So hopefully you get where that number is coming from so far. Now that money grows that $630 grows without any taxation ever again, with current tax law, you don’t ever have to pay taxes on that money again. Now, as I said, as it stands, what could change?
I mean, you could have all kinds of things change. You could have all of a sudden, they go, “Well, if you’re taking over this amount of money out of your Roth, this could be a tax law down the road who knows you’re going to have a tax on it, or it’s going to affect your social security income and or taxation of social security. And there are all kinds of things that could happen down the road. I’m just talking about how it stands right now.
Now with that person that goes and puts the money in the 401(k), that’s in the upper tax bracket, that’s a pretty decent deal. And the government misses out on that income, that 37%.
So the key idea is that the money that goes into a traditional 401(k) gives you a tax break at whatever your current tax rate is. If your tax bracket is 22%, you avoid 22% in taxes, if it’s 37% you avoid 37% in taxes, etc.
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The Biden Proposal details
Now the Biden proposal is basically saying, “It’s not fair. If you have a really high tax rate, you’re getting a better benefit out of putting $1,000 away for retirement than the person in a 10% tax bracket,” so that is in essence what he is saying in his tax proposal. Now what is being proposed is to change that to a flat 26% tax credit.
Tax credits work differently than tax deductions. With a credit, you get a dollar for dollar reduction in your taxes owed for going and putting that money into the 401(k) plan. So now he is proposing to level the playing field. Everyone would get the 26% credit, regardless of your income bracket. So for every $1,000 you contribute to a 401(k), you would get a $260 tax credit, no matter what your income is.
Now, if you look at that and you say, well, what’s the difference to the government between that? Well, in essence, what they’re saying is that that would equalize things and it would be revenue neutral, meaning that the government’s revenue wouldn’t change as a result of that.
Now, what do you see as a problem with the revenue neutrality Jim, in general?
Losing incentives
Jim: Well, I think the whole idea of it being revenue neutral is a big problem because people respond to incentives, right?
Yeah, there is a much lower tax advantage for those who are in higher tax brackets. And since the ones who are in the higher tax brackets are the ones who actually set up the plan—the employers—you can see where there might be a problem.
If the tax advantages aren’t there for people that are running the plans and making the decision to have the plans and paying for the plans. If those incentives aren’t there, then they’re very likely to not have the plan anymore. So what that does is push the opportunities for big companies that are likely to keep continuing the plans, but for small businesses, there’s a lot of small business owners that would probably just say, “I don’t want this. It doesn’t have enough advantages for me. So I’m just going to opt out and discontinue it.”
Paul: So a company that pays for administration expenses and pays for the expenses of having a 401(k), maybe there’s a cost of actually having enrollment meetings because people are not productive while the enrollment meetings are happening, or the education meetings are happening. You know, they’re not going to do that anymore. So that’s one of the risks.
And if that happens, then it’s not revenue neutral. The revenue actually goes up to the government because people aren’t contributing as much to pre-tax plans anymore because they don’t exist.
And, they wouldn’t go and maxing the plans out surely by any stretch of the imagination. So exactly right. So that it may not be revenue neutral. It may actually be beneficial for the government, but that’s, you know, that’s a good sales tool to say, it’s going to be revenue neutral. It’s not going to change the revenue coming to the government one way or another.
So one of the biggest problems here is that this proposal gets rid of the incentives for business owners to set up 401(k) plans in the first place, and that will actually hurt overall savings for retirement since the 401(k) is one of the best saving and investing tools out there.
What is the cost?
Jim: And there are other potential effects as well in terms of well, if there is a large drop in what people are saving in their 401(k)s, then that potentially means less money for investing in the economy, less investing in new companies and things like that. And so does that slow long term economic growth?
Paul: Who knows? Yeah, it can, but what I would think of more, and I would wonder if, because people aren’t saving as much, that puts more pressure on the government down the road to have more programs because they have to help people out that haven’t saved enough money, and they have to help retirees more with healthcare expenses and long term care expenses and those types of things. So yeah, all of those things come to mind now with this thing.
Now with this article on the plan, basically what’s happening is they did a calculation and they were trying to figure out what the cost was.
And they came out with this idea that, it’s this tax rate of 20.5%. And it said, and I’ll just read from the article. It says, “for example, a taxpayer with a 12% tax bracket earning 35,000 would receive a 12% deduction under current law for their traditional retirement contributions. But under Biden’s proposal, would see an effective deduction at 20.5% marginal rate higher than currently when they receive a 26% matching tax credit. By contrast, a taxpayer in a 37% tax bracket would only receive an equivalent deduction at 20.5% marginal tax rate, rather than the deduction at the 37% marginal rate that they would receive under current law.”
So the short of it is this, if your tax rate, which many, you know, you look at at a lot of people in America that are saving money for retirement, you have actually a higher than a 20.5% marginal rate, and you might be at 22% and you might be at 24% or higher than that, that it would be bad for you.
This proposal would be bad for you if your marginal tax rate is above 20.5%. But if your rate is below 20.5%, this new plan would actually be good for you, it would be better for you. Why? It is because of the differential between your marginal rate right now, and your rate that you take the money out in retirement.
So for example, if I’m in a 37% tax rate right now, and I’m getting a 37% deduction, or above that 20.5% someplace, I’m just going to use 37%. If I get a deduction right now of 37% and I pull money back out in the future that has grown in my 401(k) plan and I pull it out based on the way our tax system works. Some of that income will be taxed. If I’m not working, I don’t have any other income.
Some of the money I pull out of the 401(k) in retirement is taxed at 0%. Some of it’s at 10%, some of it’s at 12%, some of it’s at 22%. And it goes up not all of it’s at your marginal rate. Part of it is at the lowest rate. And a little bit, if you earn more than that, then the next income is taxed at 12%. And the next income above that is taxed at 22%. So it creeps up. That’s how our tax system works right now.
So let’s say, if you have a person that is, let’s say that their income is $5,525 in 2020, and they’re in a 22% tax bracket in retirement, that’s their marginal rate. If they earn one more dollar of income, it’s taxed at 22%, that’s their marginal rate, but their average rate might be much lower because some of it is at 0, some at 10%, some 12%, and some 22%. So the average rate might be 9%, or something around that.
That person that was earning income and paying taxes at a 37% marginal rate again, what the last dollar was taxed at, taking its average of 9%, is in a much better position and would be incentivized to do a 401(k) on a pre-tax basis. They avoided paying taxes at 37% so that they could pay taxes at 9% in retirement.
If you’re going to be at a higher rate in retirement, however, then this kind of tax deferral doesn’t make sense. But that’s not a lot of people. Usually, you are in a lower tax rate in retirement. You might be at a higher rate if you made a low income for most of your life, and then received a big inheritance by retirement. That’s one of the few times that the situation is flipped. If that’s the case, you would be incentivized to pay taxes now.
Messing with 401(k) plans
So in essence, what they’re doing here, bottom line, this proposal would take away the incentive to do pre-tax programs for an upper income person. And here’s the thing. The upper income person is typically the business owner that decides to pay the third-party administration expenses and the expenses for having a 401(k) plan. These things aren’t free to run, so you really need the tax incentive to set them up. And therefore that is the real issue here. Now, one of the things I want to really emphasize here, this is not a proposal.
It’s a comment on your 401(k) plan. I said this last time, but I think it bears repeating, it’s not a proposal to come in and take all your money from you and tax you and steal your 401(k) plan. People have said, “Oh, that’s, you know, they’re going to come do this.” There was a rumor many, many years ago. And I talked about this last time, there’s a lady who was an NYU professor who came in and said, “we need to change this. The 401(k) has failed and we need to come in and replace 401(k) plans with a universal pension type of plan.”
As I recall it was. And literally she had to hire a bodyguard because of all kinds of death threats. It was kind of crazy, but that’s what happened. And that just shows you how adamant people are at keeping their 401(k) plans. And don’t mess with my 401(k), don’t mess with my retirement plan, but you know, anybody that was concerned, that’s what we were getting out of that. A lot of people that did, there were enough people that emailed and didn’t understand the math. Some people just didn’t understand the math. And I’m hoping that the math makes a little bit more sense to you now.
Jim: There’s one more set of problems, also. If employers don’t have incentives for these plans, because part of the incentive too is, I want to maintain and keep good employees, and sometimes that is done with a match, right? And if all of a sudden there’s no incentive to have a plan and people start losing matches, that affects everybody, not just the highly compensated, but everybody down the line that was getting to 50 cents on the dollar or whatever the match was. If those matches go away, that hurts everybody.
Paul: And it’s a good thing to consider. It is a great thing to a great point, Jim, because if you don’t have that type of a program with a match and you don’t have the incentive to put money away for retirement. Now you’re dealing with a situation where people don’t get out of the workforce. I mean, remember when back in the 1930s, social security was instituted. One of the big reasons that social security was instituted in the first place was to get older people out of the workforce. Well, if you have older people and they haven’t saved enough for retirement, they don’t have enough money for retirement.
You’re not moving them out of the workforce into retirement, which doesn’t pave the way for the younger people coming in. You know, because companies, they are probably not going to get rid of really educated, really skilled people. And if they’ve got, you know, and if they’re, if they’re not retiring, a lot of people will leave the workforce because you know what, I’m going to retire. Now I’ve done my time. I’ve done, you know, I’m ready to move on and watch the grandkids and things like that. And younger people, well let’s make way for them.
Well, if they don’t have the retirement savings, they may not be so incentivized to leave the workforce, which can be problematic for younger people trying to get their career started later on. So that’s a really good point.
All right, you’re listening to the Investor Coaching Show. Paul Winkler, along with Jim Wood.
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