Matt Bacon        March 4, 2021

President Biden made waves during his run for office with a series of progressive legislative changes. One of those is moving closer to fruition. In a recent Senate hearing, Treasury Secretary Janet Yellen announced that she is looking into changes to current retirement plan rules. Yellen didn’t elaborate on what these changes may be, but many suspect the changes she’s exploring are the ones proposed by then-candidate Biden while on the campaign trail.

What are the changes?

The plan will replace the current dollar for dollar tax deduction for a flat tax credit of 26% for every dollar saved. Anyone in a tax bracket less than 26% will be better off with these changes while those above that threshold will be at a disadvantage.

Consider a couple in the 32% tax bracket that max out each of their current retirement plans. They avoid tax of $32 on every $100 saved in the current system. But a flat tax credit of 26% means they will only get a deduction of $26 on every $100 saved. This couple’s tax savings is reduced by nearly 20% for every $100 saved with the new changes.

The sword cuts both ways. Consider a couple in the 12% tax bracket. They’ll now get a refundable tax credit of 26% for every dollar they contribute. Their tax savings will be more than double what they were before the change. It’s a big incentive to sock away money if your in a bracket that’s less than 26%.

Critically, all dollars in the plan will still be tax-deferred. Earners in brackets higher than 26% won’t find themselves in a situation with basis in their retirement plans. Dollars are still fully deductible but at a maximum rate of 26%.

Strategies for High Earners

The changes make saving to a retirement plan less palatable for higher income earners. Savings strategies will need to adjust. We have some thoughts:

  1. Consider contributions to a Roth 401(k) in the amount of the lost tax savings. The maximum tax savings for someone over age 50 is 26% of $26,000 under the new rules, or $6,760. The maximum savings for someone in the 32% bracket is $8,320 under the current rules. The 32% bracket individual will lose out on tax savings of $1,560. This works out to a contribution of $4,875 ($1,560 ÷32). Consider making a contribution to a Roth 401(k) in that amount as there is no tax deduction on that portion of the contribution.
  2. Roth conversions are less attractive. The maximum deduction may be capped but the maximum tax on a conversion is not. Refer to the first point above and be careful on converting large amounts. It may be better to perform partial conversions or simply delay conversions until retirement if you expect to be in a tax bracket less than 26%.
  3. Take advantage of after-tax contributions to retirement plans where you can. Some 401k plans allow you to contribute additional sums of money above and beyond the $19,500 limit ($26,000 limit for those over age 50) on a non-deductible, after-tax basis. The benefit to this strategy is that all contributions grow tax deferred. Some plans will allow you to convert these after-tax amounts to a Roth IRA. Online articles often call this a “Mega Backdoor Roth”. This strategy will become even more attractive given the 26% cap on deductions.

Gentle reminder from the CHA team – consult with your advisors before making any big changes. Some of these strategies are complicated and difficult to get right without a good team behind you. Talk it over with your advisor and put your best foot forward.

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