Despite the hyper partisan times that we are living in, there is one thing in my experience as a financial planner that unites both Republicans and Democrats: Taxes.
I work with people on all sides of the aisle, and they all want to know what they can do to lower their taxes.
As we get closer to Election Day, the polls are showing that Joe Biden has a good chance of winning, which means it’s important to understand what his election could mean to your taxes.
Specifically, I want to address his plan that would change the tax benefits for the main source of retirement savings in America, the 401(K).
Before we get into the details, a quick refresher on how 401(k) plans currently work.
A 401(k) is a retirement plan that is offered through your employer, where employees make contributions into the plan so that they can invest for their own retirement.
To incentive savings, the contributions by the employee are tax-deferred – meaning, you don’t have to pay taxes on the contributions you make in the current year, and will instead defer payment of taxes until you distribute the funds.
When you contribute to a 401(k) plan, you are able to defer taxes at whatever your highest tax rate is.
For instance: If you are making $50,000 as an unmarried person in 2020, your highest tax at the federal level would be 22%.
If you were to make a $100 contribution to your 401(k) in 2020, that would lower your taxable income by $100, which means you would save $22 in taxes ($100 X 22% = $22).
If your income were higher and you were at the 37% tax bracket, then a $100 contribution to your 401(k) would again lower your taxable income by $100, but since you are in a higher tax bracket, it would allow you to save $37 in taxes ($100 X 37% = $37).
As you can see, the higher your income, the higher your tax benefit.
All clear? I hope so! Onto Joe Biden’s proposed changes:
Instead of letting people defer taxes at their highest tax rate, Joe Biden’s tax plan would give everyone who contributed to their 401(k) a flat percentage tax credit for every dollar they contributed to their 401(k) plan.
While the percentage isn’t set, some analysts estimate it will be 26%. Here’s how this would look in practice:
You would no longer be able to defer taxes on your 401(k) contributions, and would have to pay taxes on that money in the year that you earn it. However, after you make a contribution, the government would give you a tax credit, which you could either use to pay your tax liability or potentially keep in your pocket.
If you made a $100 contribution to your 401(k), regardless of your income, then your tax credit would be $26.
For people whose tax bracket is 24% or less, then this 26% credit would result in more tax benefits than our current system offers. However, if your tax bracket is 32% or higher, then your tax benefit would be less than it currently is.
Is this a drastic change? No. But it could influence how you should allocate your investments to get the most tax savings.
For instance, if you are in the higher tax brackets, a 401(k) contribution may not be the sure thing that it currently is (since you will get less tax benefit from it), and it could mean you might want to look at other vehicles to grow your investments and save on taxes.
Want to learn more tax strategies? Enroll in my free course teaching you how to lower or eliminate your taxes in retirement at RetireTaxBomb.com. You can also reach me at scott@dev-forthrightfinances.pantheonsite.io with questions.