Biden Plan to Improve the 401(k) Does the Opposite

I’ve written a couple of recent columns on fixes needed to restore the value of 401(k) and other deferred tax retirement plans for young median-wage workers. The presidential campaign of Joe Biden and Kamala Harris has a proposal aimed at that issue. It’s a step almost exactly in the wrong direction.

Under current policy, standard deferred tax retirement plans, including 401(k)s, IRAs and other variants, are taxed at distribution time rather than contribution time. (“Roth” variants do not have this feature.) Biden-Harris propose to tax the plans at both contribution and distribution, and to offer a refundable tax credit to make up for the double taxation. The idea is justified on the basis of fairness, since avoiding tax at contribution time is worth only 12% to most middle-income workers, but 37% for the highest-income workers.

This represents a common misconception, which is that the tax advantage of 401(k)s lies in the fact that contributions are not taxed. But if you make a $100 contribution, and it doubles in value by retirement, and you are in the same—say 12%—bracket both times, it doesn’t matter if you pay tax at the beginning and have $88 double to $176, or pay tax at the end and have $100 double to $200, which is $176 after paying 12% tax.

Using data from the Bureau of Labor Statistics we see that the bottom quartile of households average near-zero marginal federal, State and local income tax rates over their working years and in retirement. Second quartile households, about $35,000 to $52,000 annual income, average about 10% during working years and 3% in retirement, so they gain 7% of the total 401(k) account value by paying at distribution rather than contribution time. The third quartile pays 18% while working and 15% in retirement, so they gain 3%. The top quartile, above $80,000, pay 26% while working and 32% in retirement, so they lose 6% by deferral.