The Reimagination of Conventional Retirement Savings Wisdom

Journal of Financial Planning: August 2021

Dan Johnson is an assistant professor at the College for Financial Planning and a part-time instructor for Kaplan Professional and Boston University. He primarily focuses on retirement, tax, and estate planning for individuals, families, small businesses, and athletes/entertainers. Dan resides in Chicago.

JOIN THE DISCUSSION: Discuss this article with fellow FPA Members through FPA's Knowledge Circles​​​​. ​​​

FEEDBACK: If you have any questions or comments on this article, please contact the editor HERE. 

On March 11, 2021, newly elected President Joe Biden signed into law the American Rescue Plan Act, a $1.9 trillion economic stimulus package designed to lift the U.S. economy out of recession due to the COVID-19 pandemic.¹  The act primarily centers on rebate checks, credits, subsidies, and exclusions,²  but that is not what has everyone talking. Instead, it is Biden’s proposed tax plan—which primarily focuses on America’s high-income and wealthy individuals.

Though initial proposals are often a far cry from final results, changes put forth include marginal rate increases, itemized deduction limitations, retirement savings credits, payroll tax increases, capital gains taxation, step-up basis and lifetime estate exemption, and student loan forgiveness (Woehrle, Johnson, and Angell 2021). All deserve attention, but the first three perhaps more so because of their implementation speed, administrative feasibility, and power to dramatically alter the retirement savings landscape.

Conventional Wisdom 2.0

Conventional planning wisdom tells us two things. First, you should start saving early and often so you can enjoy the miracles of compound interest. Second, tax avoidance (not evasion) is perfectly acceptable and encouraged, and you should only pay what you owe. As such, the choice of retirement saving vehicles becomes a critical decision toward long-term financial success.

Generally speaking, lower marginal taxpayers will benefit more from post-tax accounts such as Roth 401(k)s and IRAs because their marginal rate will likely be higher in future years. Conversely, higher marginal taxpayers will favor pretax accounts such as 401(k)s and 403(b)s. Yet with Biden’s newly proposed retirement savings credit, traditional wisdom would change. Here’s why: pretax accounts would no longer receive a coinciding deduction at the taxpayer’s marginal rate. Instead, taxpayers would receive a credit equal to the contribution amount, times a stated percentage, which estimates put at 26 percent. This credit would apply regardless of a taxpayer’s income and would not impact Roth-styled accounts (Woehrle, Johnson, and Angell 2021).

The credit clearly incentivizes lower-income taxpayers to save more for retirement. Specifically, 10–22 percent marginal taxpayers will now favor pretax accounts because they will receive a greater deduction (26 percent) despite their lower tax bracket. Meanwhile, 32–37 percent marginal taxpayers will be limited to a 26 percent deduction and therefore pay 6–11 percent more in taxes, which creates the issue of double taxation (Woehrle, Johnson, and Angell 2021). But why?

Remember that all subsequent withdrawals from pretax accounts are subject to full taxation. Meaning, if a 37 percent marginal taxpayer contributed $10,000 to their traditional 401(k), they would receive only a 26 percent credit and pay 11 percent more in up-front taxes. Assuming there is no subsequent 11 percent “makeup” credit, the taxpayer would then pay the full 37 percent rate on withdrawals, making their true marginal rate 48 percent (Woehrle, Johnson, and Angell 2021)! But it gets worse, as many states rely upon federal adjusted gross income (AGI) when calculating their taxes. Thus, our 37 percent taxpayer may also face double taxation at the state level since they will not receive a full contribution deduction, nor adjustment credit upon withdrawal.

Adding Fuel to the Fire

Currently, the top marginal rate is set to 37 percent once taxable income reaches $523,600 (single) and $628,300 (joint), and taxpayers are entitled to the greater of itemized deductions or the standard deduction ($12,550 single, $25,100 joint). Biden’s plan, however, would revert to the pre-TCJA (Tax Cuts and Jobs Act) rate of 39.6 percent and take effect once taxable income exceeded $400,000; thus compressing and eliminating the 32 percent and 35 percent marginal brackets, respectively (Woehrle, Johnson, and Angell 2021). Additionally, the plan would cap itemized deductions at 28 percent, which is similar to the pre-TCJA “Pease Limitation” (Woehrle, Johnson, and Angell 2021).

Lower marginal taxpayers will be relatively unaffected, but those in the 32 percent-plus brackets will likely experience tax increases. Worse yet, if you combine these changes with the savings credit, you now face the “doomsday trifecta.” For example, suppose a taxpayer had $450,000 of taxable income, itemized deductions, and made a $10,000 contribution to their traditional 401(k). Normally their marginal rate would be 35 percent, and any additional itemized deductions or pretax savings would receive a corresponding deduction. The taxpayer would also hopefully withdraw or convert that money at lower rates later on.

However, the doomsday trifecta would substantially increase the tax. First, their marginal rate would increase from 35 percent to 39.6 percent. Next, their itemized deductions would be capped at 28 percent. Finally, their retirement contributions would only receive a 26 percent deduction. Altogether, the combined effect is a new marginal rate of 64.8 percent, which is a 29.8 percent tax increase (Woehrle, Johnson, and Angell 2021)!

Avoiding Doomsday

Admittedly, we still do not know who the $400,000 taxable income limit applies to (for example, single or joint filers), and if itemized deductions will be phased out. However, if these are the only changes, then we likely can rely upon conventional wisdom: lower marginal taxpayers using Roth accounts, and higher marginal taxpayers using pretax accounts. Yet that strategy becomes inverted once we introduce the savings credit. Why? Because despite the up-front tax to higher marginal taxpayers using Roth accounts, any subsequent growth and withdrawals are tax-free, thereby avoiding the double taxation effect discussed earlier.

Again, there are unknowns here such as which pretax accounts face this savings credit, and if higher marginal taxpayers will receive a back-end credit to circumvent double taxation. Still, higher marginal taxpayers should be prepared and consider strategies such as:

1. Roth and/or after-tax contributions in employer-sponsored retirement plans
2. Conversions and/or back-door Roth IRA contributions
3. Transferring pretax IRAs into employer plans (if allowed) to avoid IRA aggregation rules
4. Establishing (or amending) a retirement plan with a Roth option (if the taxpayer is a business owner)
5. Utilizing brokerage accounts since long-term capital gains are only taxed at 0–20 percent rates—at least for now

What About Wealth?

Biden’s plan also includes capital gains, step-up basis, and lifetime estate exemption. Briefly explained, any long-term capital gains exceeding $1 million in taxable income would now be taxed as ordinary income, causing rates to increase from 23.8 percent to 43.4 percent (3.8 percent Medicare surtax included) (Woehrle, Johnson, and Angell 2021). Meanwhile, beneficiaries of inherited assets would no longer receive a step-up in basis under IRC Section 1014(a), with the exception being “income in respect of decedent” assets (Woehrle, Johnson, and Angell 2021). Lastly, the lifetime estate/gifting exemption would revert to an inflation adjusted/pre-TCJA amount of $5.85 million (single) and $11.7 million (joint), with the 40 percent estate tax rate still in effect (for now) (Woehrle, Johnson, and Angell 2021).

Undoubtedly, these changes would result in significant wealth taxation, but there is a sliver of hope for those in tax jeopardy. First, the IRS has stated it will not retroactively “claw back” taxpayers using the current TCJA estate exclusion before the new exclusion applies.³  Second, wealth taxes create a severe administrative burden. Unlike the previously discussed changes, wealth taxes rely upon fair market value and basis determination. But what happens when taxpayers do not know either, or possess highly illiquid assets? Furthermore, how will taxpayers report this information, when will the tax occur, and are any assets to be excluded or qualify for an exemption? Regardless of the situation, it’s easy to imagine hordes of costly appraisers, accountants, compliance officers, and legal arbiters settling disputes between the federal government and taxpayers (Levine 2020). Finally, history also tends to repeat itself. For example, in the past 50 years there have been two major attempts at implementing wealth taxes in the United States. Both focused on step-up basis elimination, but ultimately failed due to the administrative burdens for financial and government institutions (Levine 2020).

Overall, the ease and speed at which tax policy can be implemented is often the deciding factor in what does (and does not) get passed. Thus, taxpayers can breathe a little easier in the wealth tax realm (for now) but should consider revisiting Obama-era estate planning strategies such as lifetime gifting, life insurance trusts, and charitable trusts.

Where’s My Slice?

Desperate and impatient, many states have side-stepped the federal government and begun rolling out their own unique tax initiatives. Leading the charge, perhaps unsurprisingly, are California and New York.

In 2020, California lawmakers proposed both an income and wealth tax bill. Neither bill passed, but they are back in 2021 and with more support. Under Assembly Bill 1253, the top marginal rate would increase from 13.3 percent to 16.8 percent, further cementing California’s status as the highest income taxing state in the country.⁴  Meanwhile, Assembly Bill 310 would annually levy a 1 percent and 1.5 percent tax on net worth above $50 million and $1 billion, respectively, and apply the tax to assets and liabilities held worldwide—not just California.⁵  There is also a provision (possibly retroactive) that makes vacating individuals subject to the tax for up to 10 years after leaving California, even if they spend only 60 days inside the state!⁶  This means many former Californians, part-time residents, and visitors could be subject to the tax, even if their wealth was created after leaving the state. Surely this provision will run afoul of the U.S. Constitution’s Due Process and Commerce Clauses, but if passed, California would be the first state to annually tax a person’s wealth, possibly tempting other states into following suit (Pogroszewski and Smoker 2020).

Not to be outdone by its West Coast rivals, New York recently passed legislation increasing income taxes for its highest earners. Specifically, rates will increase from 8.82 percent to 9.65 percent for single and joint filers whose income exceeds $1.1 million and $2.2 million, respectively, and apply retroactively starting January 1, 2021.⁷  The state is also adding two new tax brackets that will apply regardless of filing status: Income over $5 million and $25 million will now be taxed at 10.3 percent and 10.9 percent, respectively.⁸  Coupled with New York City’s 3.88 percent income tax, the city’s highest earners now have a combined state-and-city income tax rate of 14.78 percent—which surpasses California’s rate of 13.3 percent and Portland, Oregon’s combined rate of 13.9 percent.⁹  Lastly, business franchises are now paying more taxes, too: an increase from 6.5 percent to 7.25 percent through 2023.¹⁰

Notably, and similar to California, New York is also exploring an annual wealth tax, specifically a “mark-to-market” tax on billionaires. This tax would require its wealthiest residents to pay income taxes (not capital gains taxes) annually on their appreciated assets, even if they do not sell them.¹¹  Thus, a New York City billionaire owning securities with a fair market value of $3 billion, and a basis of $2.5 billion, would owe $73.9 million in taxes ($500 million x 14.78 percent)!

Pack the Bags

Dual sovereignty allows states to create tax schemes independent of the federal government (Pogroszewski and Smoker 2020). Yet like their big brother, states usually favor marginal rate, deduction, and credit changes, rather than wealth taxes, because of their ease and feasibility. Nevertheless, states are becoming increasingly aggressive and creative to collect what they perceive as their fair share of taxes. Therefore, many residents and businesses of California, New York, and other high-income taxing states are beginning to flee to lower taxing states such as Florida, Nevada, Tennessee, Texas, and Washington. In fact, from July 2019 to July 2020, California and New York were first and third in terms of population loss, while Florida and Texas led states in growth (U.S. Census Bureau 2020). Though nonfinancial reasons could be contributing to those numbers, tax is a strong influencer and should not be overlooked.

If not already done so, advisers to high earners and wealthy individuals may want to discuss relocation and work quickly to establish domicile in a tax-friendly state. This takes work, but it can save thousands, if not millions, in taxes. It is an especially opportune time to move considering the COVID-19 pandemic has pushed everyone toward remote work. After all, why live in an unfriendly tax state if you can just do your job online now?

Conclusion

Despite speculation, there has been an unprecedented number of changes over the past several years, thus making anything seem possible right now. Therefore, advisers should start thinking ahead, having early-bird discussions, and running multiple tax projections showing the potential impact of these changes. In the best-case scenario, nothing severe happens and clients walk away happy and appreciative of their adviser’s proactive approach. That is likely wishful thinking, but by being proactive, advisers will be well positioned to navigate clients through this new tax regime. If not, we may need to revisit conventional wisdom one more time and change the phrase “death and taxes” to “death by taxes.” 

Endnotes

1. See American Rescue Plan Act of 2021, H.R. 1319, 117th Cong. (2021). www.congress.gov/bill/117th-congress/house-bill/1319.
2. Ibid.
3. See Unified Credit Against Estate Tax; in general, 26 C.F.R. § 20.2010-1(c) (2021). www.law.cornell.edu/cfr/text/26/20.2010-1.
4. See Personal Income Taxes: Additional Tax, A.B. 1253, 2021–2022 Reg. Sess. (Cal. 2021). https://leginfo.legislature.ca.gov/faces/billTextClient.xhtml?bill_id=202120220AB1253.
5. See Wealth Tax, A.B. 310, 2021–2022 Reg. Sess. (Cal. 2021). https://leginfo.legislature.ca.gov/faces/billTextClient.xhtml?bill_id=202120220AB310.
6. Ibid.
7. See Fiscal Year 2021–22 Executive Budget Bill, A.B. A3009C, 2021–2022 Reg. Sess. (NY. 2021. (enacted). https://legislation.nysenate.gov/pdf/bills/2021/A3009C.
8. Ibid.
9. Ibid.
10. Ibid.
11. See Billionaire Mark-To-Market Tax, A.B. S4482, 2021–2022 Reg. Sess. (NY. 2021). https://legislation.nysenate.gov/pdf/bills/2021/S4482.

References

Levine, Jeffrey. 2020, September 30. “The Biden Tax Plan: Proposed Changes and Year-End Planning Opportunities.” Kitces Nerds Eye View. www.kitces.com/blog/biden-tax-plan-cuts-democrat-proposal-capital-gains-396-increase-estate-exemption-retirement-credit/.

Pogroszewski, Alan, and Kari Smoker. 2020. “State tax strategies for athletes and entertainers: Residency and SALT deduction limitations,” (Webinar, Strafford, June 18, 2020). www.straffordpub.com/products/state-tax-strategies-for-athletes-and-entertainers-residency-and-salt-deduction-limitations-2020-06-18.

United States Census Bureau. 2020. “State population totals: 2010-2020.” Accessed May 5, 2021. www.census.gov/programs-surveys/popest/technical-documentation/research/evaluation-estimates/2020-evaluation-estimates/2010s-state-total.html.

Woehrle, Christopher, Dan Johnson, and Michael Angell. 2021. “President Biden’s Tax Plan: The Implications for Advisers and their Clients,” (Conference presentation, Kaplan Thought Leadership Series, Online, April 22, 2021). www.kaplanfinancial.com/wealth-management/resources/events.