(This post originally appeared on The Guardian)
The 401(K) retirement plan has proved an extremely popular – and cost-effective – retirement benefit that’s provided by millions of small business owners around the country to their employees. If Joe Biden wins, they could be in for a major shake-up – one that could benefit tens of millions of Americans.
Up until now, the rules were fairly simple: employees could contribute a pre-tax amount of their compensation for their retirement and employers could match that amount up to a total combined contribution of $57,000 per year for people under 50 years old. Small business owners benefit from these plans because not only can their employees put away money for themselves for retirement but the more they save, the more the owners can save.
But 401(K) plans have a problem: they favor higher earners. That’s because the more an employee makes, the more of a deduction can be taken. That lowers their taxable income and therefore results in paying less taxes. So if a person is earning $200,000 per year and contributes 10% to a 401(K) plan her earnings would be taxed at $180,000 and that’s a big tax savings. But if a person is only earning $40,000 and contributes the same (which is harder to do given the cost of living) then their taxable income would be $36,000 and the amount of tax savings they would reap would be much less due to the lower brackets. The result is that people with lower income are less incentivized to save for retirement.
That’s a problem for small business owners too. Why? Because the less your employees put away for retirement the more risk that, as they get older and remain with your company, they may come back to you for additional help when it’s time to retire because they haven’t saved enough. You can say sorry and turn them away. But – if you’re like many of my clients (and I’ve seen this numerous times) – you will probably need to step up in some way with additional assistance. No one wants to be in that situation.
Biden’s plan would turn 401(K)s upside down. Instead of allowing contributions to be deducted from income people would be eligible for a refundable tax credit. The plan isn’t fully fleshed out and the amount of the credit has yet to be determined. But let’s assume it’s 26% of an employee’s contributions – the most recent number thrown around. So if that person contributes $100 during the year she will get a $26 credit against the taxes she owes. If she doesn’t owe that amount she’ll get the cash back. If you do the math (and I recommend you ask your accountant to walk you through this), lower earners at lower tax brackets would be able to save more on their taxes under Biden’s plan due to this credit than the current pre-tax deduction they’re now allowed. The opposite would be the case for higher earners.
Biden’s proposal is not without its critics. “You’re disincentivizing those small business owners from having that plan any more,” Brian Graff, the CEO of the American Retirement Association, told FOX Business. “Not only is it unfair to those small business owners, it’s going to reduce the likelihood that they’re going to offer those benefits to their employees. And that’s particularly acute in a challenging time like now.”
But the former vice-president believes the proposal will make things more equitable. “Current tax benefits for retirement savings provide upper-income families with a significant tax break, while providing a limited benefit for low- and middle-income workers,” he says on his website.
Regardless of who you believe, the fact is that the current system has a big problem: people working at small businesses are not saving for their retirement as much as they should and small businesses – who employ more than 50% of the country’s workers – are not doing enough to motivate them.
Just half of US households have retirement accounts, according to a study from the Federal Reserve and new data from the Employment Benefit Research Institute confirms that “nearly half of employees are concerned with their household’s financial wellbeing, citing saving for retirement and having savings in case of an emergency as top sources of financial stress.” Teresa Ghilarducci, a professor of economics at the University of Notre Dame warns that – despite the many benefits business owners themselves receive from offering 401(K) plans – “just 40% of workers were covered by a retirement plan through their workplace in 2017.”
The problem isn’t whether higher earners will save enough. I’m not really worried about them. The real problem is that middle- to lower-income families aren’t thinking of the future. Too many of the employees at my clients ignore their retirement benefits. It’s possible that if Biden’s proposals can be proven to save them even more on their taxes, they would be encouraged to put more money away for the future. Given the current status quo, I think his proposal is worth trying.