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During the presidential election, one proposal put forth by the Biden campaign was to switch traditional 401(k) contributions from a tax deduction to a tax credit. With today’s current tax regime, when you make a contribution it reduces your taxes at your marginal rate, which for me is 22%, or 22 cents for every dollar I contribute to my 401(k). The proposal would change this from a deduction to a 26% credit. So, what does that look like?
Credits Versus Deductions
I just finished reading A Fine Mess by T.R. Reid for our family book group. Besides introducing me to things like “rifle shot” tax provisions (i.e. tax breaks targeted at individual companies) and BBLR (“broad base, low rates”), the author also examines the difference between deductions and credits. By reducing taxes at the marginal rate, deductions tend to favor those with higher incomes over low incomes. On the other hand tax credits are generally income agnostic.
Reframing the mortgage interest deduction as a credit can make this distinction seem almost obvious. To do so, the book quoted Stanley Surrey, a Harvard professor who served in JFK’s Treasury Department:
The federal government wants to help some Americans pay their mortgage. Here’s how it works: For a couple with $200,000 of income, and a mortgage interest payment of $1,000 per month, the government will pay the bank $700 and the homeowners will have to pay only $300. For a couple with $20,000 of income and a mortgage interest payment of $1,000 per month, the government will pay $190, leaving the couple to pay $810. For a couple making less than $10,000, the government will pay zero — so the low-income couple has to pay the full $1000 of mortgage interest.
While the mortgage interest deduction was made mostly obsolete by the TCJA in 2017, the same idea extends to 401(k) deductions.
So, if you’re looking to address the wealth gap, deductions are a great place to start.
To better understand the 401(k) deduction-versus-credit topic, let’s take a look at an example. First the assumptions:
- 2020 tax brackets for Married Filing Jointly
- Standard deduction of $24,800/MFJ
- Only one spouse working with total household salary of $100,000
- We’ll ignore other above the line tax deductions to make things easier
- We make the maximum 401(k) contribution of $19.5k
- Virginia state income tax rates, with maximum marginal rate of 5.75%
- To make things easier, assume that the 401(k) balance is taxed at the tax payer’s current marginal rate. I’ll put together a post in the future of why this might be a reasonable assumption, but basically it’s along the lines that the Frugal Professor laid out here.
First, let’s look at the pre-tax deduction scenario. After applying the standard deduction and the 401(k) contribution, our example taxpayer has $100k – $24,800 – $19,500 = $55,700 of taxable income. This taxpayer has a marginal rate of 12% and will owe $6,289 in federal tax and $2,945 in VA state income tax. Assuming the marginal rate for withdrawal means that in today’s dollars, the 401(k) has an additional tax burden of $3,461 for a total tax burden of $12,696, a 12.7% average tax rate.
What happens if the tax paper chose the Roth option? Now, taxable income is $100k – $24,800 = $75,200. The marginal rate is still 12%. Federal tax owed is $8,629 and VA state tax is $4,067. The Roth 401(k) balance has no tax burden, and total tax burden is $12,696, again with a 12.7% average tax rate. You’ll notice this is the same tax burden. Why? Because the marginal rate at both the contribution and withdrawal ends are the same. If that holds true–a big if!–then contributing to either has the same outcome.
Finally, what if it was done as a credit? Taxable income is the same as the Roth scenario, $75,200 and the federal and state tax due is also the same as the Roth scenario. But now, we credit the 401(k) balance with an additional 26% boost, turning the $19,500 contribution into $24,570. Using the same assumption of current marginal rate in future withdrawal, we owe an additional tax of $4,361 for a total tax burden of $17,057. But this is deceptively high because our 401(k) balance is also higher! A more accurate way to look at it is to sum the positives and negatives and compare with where we started:
= Salary – Federal & State Taxes + 401(k) credit – Future 401(k) taxes
This gives an effective tax burden of $11,987 and an average tax rate of 12%. A clear win in our example.
As Salary Varies
But things get complicated as income increases. Remember, deductions favor higher incomes, so we’d expect the 401(k) credit option to lose out the Roth and traditional. And it does. Here’s a graph that summarizes the difference:
Looking at that graph, you can see that for incomes less than $100k, the 401(k) credit system wins, but once you cross the $100k sweet spot, the pre-tax deduction wins briefly before settling into a lock step with the Roth option. And at each marginal tax bump, the traditional briefly beats the Roth option, before they converge again.
Most of my blog readers won’t be in the $400k salary range, so here’s the same graph zoomed in to the $40k to $200k range:
It seems the $105k to $130k range is the trickiest. It makes sense in that range to take advantage of the pre-tax contributions to minimize the average tax rate. But if the 401(k) deduction turns into a credit, the taxpayer moves into the worse case scenario.
All of the previous analysis was with Married, Filing Jointly. But what if you’re Single? The graph looks pretty similar, just shifted a bit:
After seeing the relationship between the Roth and traditional 401(k) options, I’m thinking about switching a portion of my 401(k) contributions into Roth contributions in 2021. I have no idea if Biden’s tax proposals will see the light of day, but if they do, at least part of my bet will be hedged.
Anything else I should consider here? Are you planning on making any contribution adjustments to your 401(k)? I’d love to hear about it in the comments.