Biden plan to improve 401(k) does opposite

The presidential campaign of Joe Biden and Kamala Harris has a proposal aimed to restore the value of 401(k) and other deferred tax retirement plans for young median-wage workers. 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. 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.
Therefore, if fairness is a consideration, what matters is not the worker’s marginal income tax rate at contribution time, it’s the difference between the rate at the time of contribution time and the rate at the time of distribution. If anyone is treated unfairly currently, it’s top quartile earners.
But changing the rules to favour high earners is a bad idea for two reasons. The first is that there is more of a variety of situations within income quartiles than among them. Some people in all quartiles get a great advantage by deferring, some take substantial losses. People move among quartiles. Any fixed based on average tax rates will introduce as much new unfairness as it fixed old unfairness. Second, the Biden-Harris proposal ignores the purpose of 401(k)s, which is to encourage retirement saving, not to remedy inequality. The plan should be designed for maximum encouragement at minimum expense. Inequality is much better addressed through other tax changes, such as increasing the Earned Income Tax Credit or increasing marginal income tax rates.
The other problem of the Biden-Harris proposal is focussing on the minor advantage of tax-deferred retirement plans and overlooking the major one. Imagine someone started a 401(k) in January 1980 (when they were introduced) at age 25, and paid $100 per month—increasing with inflation—into an S&P 500 Index fund with no fees. At the end of 2019,
at age 65, this person would have contributed a total of $105,698 and
the account would have grown to almost exactly 10 times that amount,
or $1,056,952.
In a taxable account, an investor in the maximum current tax brackets — 37% on income and 20% on capital gains — would see the government take 59% of the end total, leaving only $431,356. The reason is the government doesn’t tax just once; it taxes the original contribution, all reinvested cash flows, the cash flows from the reinvestments and then the capital gains at the end. And don’t forget about inflation, which takes a third, leaving purchasing power of $287,575.

—Bloomberg