Tag: taxation

Originally published at Forbes.com on October 4, 2020.

 

Tax breaks for pensions?

No, I’m not talking about the small number of states which don’t tax retirement income.

I’m talking about the fact that anyone who receives a traditional pension gets a tax break.

After all, generally speaking, compensation from one’s employer is counted as taxable income. Any form of compensation that is exempt from taxes is a tax break. The most well-known and acknowledged of these is the exemption of employer health insurance subsidies, which have indeed been blamed for our ever-increasing health care costs as Americans are insulated from those costs.

But traditional pensions are also a form of tax break. Workers accrue pension benefits by earning service accruals while you work. It becomes their own benefit when they become vested, and it cannot be taken away. But they don’t pay taxes until they start collecting their checks at retirement. This is exactly the same sort of income-deferral as with a 401(k).

At the same time, some workers, particularly in the public sector, are required to pay contributions, similar to an employee’s own 401(k) contribution. Where these contribution requirements exist in the private sector, the tax benefit is equivalent to a Roth 401(k). The contributions are paid on an after-tax basis, but then the portion of their retirement benefit that’s determined to have been paid for by the employee contributions is tax-free. (There’s a complex calculation, laid out by the IRS, to determine this portion.) However, for public sector plans, individual employers can arrange with their employees/unions to “pick up” the contributions, so that they are treated as pre-tax contributions, in which case, again, they function in the same way as a traditional 401(k), with taxes deferred until retirement.

Now, in the same manner as a 401(k) already has limits on how much employers and employees can set aside with tax deferral, there are limits to how much an employee can receive in a traditional, tax-qualified pension plan:

In the private sector, an employee can receive up to $230,000 in tax-qualified pension benefits from a given employer (the 401(a)(17) limit), and the pension benefit can be calculated based on at most $285,000 in pay (the 415 limit).

If employers promise pension benefits above this amount, they are required to follow strict requirements around “constructive receipt” to avoid the recipients being liable for taxes right away. What’s more, they can’t guarantee them; that is, unlike qualified pension funds, any money set aside can only be in funds which are hypothetical and contingent, and can be taken by creditors in case of bankruptcy rather than being wholly protected. If they do choose to set aside money, for instance in what’s called a “Rabbi Trust” because the first such trust was established for a rabbi, the fund is protected from employers choosing to claw it back for other uses but is not truly considered to be money set-aside by the company; the contributions don’t have any special tax treatment and the investment returns over time are also taxable to the company.

In the public sector, the same limits apply (though with some grandfathering), but the restrictions are essentially toothless. In Illinois, for example, the Illinois Pension Code establishes that each state public pension system — for teachers, for state workers, for public university/college employees, for judges and for the legislators themselves — will have not just a qualified pension fund but a separate “excess benefit fund” specifically to eliminate the impact of the 415 limit. As with a private sector excess benefit plan, the benefit promises/trust fund assets are not protected in case of insolvency (though, of course, to the extent that this is a “penalty” for providing high pensions to executives, it’s much less meaningful than for a company for which bankruptcy is a real risk).

However, the state easily circumvents the requirement to pay taxes on the investment returns in their funds; here’s the language from the Illinois Municipal Retirement Fund plan document:

“Income accruing to the Trust Fund in respect of the Plan shall constitute income derived from the exercise of an essential governmental function upon which the Trust shall be exempt from tax under Code Section 115, as well as Code Section 415(m)(1).”

California, likewise, has similar provisions to circumvent limits for its highly-paid employees, as reported, for instance, at the LA Times in 2018 and the Sacramento Bee in 2019, which found that over 1,000 individuals received such pensions in California.

Unfortunately, there is no convenient list of which states, if any, don’t circumvent IRS limits for public employees.

Which brings me back to 401(k) plans, and the Biden plan to swap out tax-deferral for a modest tax credit (see my original article and a follow up with more details).

Remember, again, that the claim is that the 401(k) plan is unfair because higher-income people benefit more from its tax break than lower-income people, because they are in higher tax brackets. I’ve attempted to explain that the tax break for 401(k) savings is not what it appears to be: it’s not a “tax deduction” in the same manner as one can deduct charitable contributions, for example, but the deferral has the effect of enabling taxpayers to pay taxes based on their post-retirement total effective tax rate rather than their current marginal tax rate, and exempts investment income from taxes.

And, again, the existing 401(k) system limits employee contributions to $19,500, plus a $6,500 catch-up contribution for the years just prior to retirement. Employers can also contribute $57,000 on employees’ behalf. If your employer doesn’t offer a plan and you save for retirement through an IRA, your limits are considerably lower, $6,000 plus a $1,000 catch-up option.

Which means that ambitious retirement account savers are already at a disadvantage, in terms of taxes, relative to those who have defined benefit pensions. If the Biden plan is implemented, the disadvantage of higher-income savers will be even more lopsided.

It might be tempting to say this is simply an appropriate and proper incentive for employers to (re-)offer traditional pensions. But, in an environment in which this is simply not going to happen, the real inequity is not between pension-receiving and 401(k)-receiving workers, but between public and private sector workers. And I fail to see why public sector workers should receive favorable tax code treatment.

 

December 2024 Author’s note: the terms of my affiliation with Forbes enable me to republish materials on other sites, so I am updating my personal website by duplicating a selected portion of my Forbes writing here.

Originally published at Forbes.com on September 17, 2020.

 

It seems that my crusade to educate readers on the Biden 401(k) plan (and, yes, others’ reporting on the subject) has not gone unnoticed. But have those reporting on it truly studied up on how Biden’s plan would work or, more importantly, how 401(k) plans and 401(k) taxes work, generally speaking? Do they, in other words, merit the Jane the Actuary Seal of Approval?

Remember: the two tax benefits of a traditional 401(k)/IRA are the fact that (1) investment earnings are not taxed and (2) taxes are paid based on total effective tax rates at retirement rather than one’s current marginal (top) tax rate. For Roth plans, the investment-income exemption is paired with the ability to “lock in” your current marginal rate if you expect it to be higher in the future (if you expect to earn more in the future or expect the government to hike taxes). (See “A Refresher Course On 401(k) and IRA Tax Benefits – For Joe Biden’s Advisors, Too.”)

Joe Biden’s plan, on the other hand, would replace this favorable tax treatment with a government-provided “match.” The details are somewhat murky but appear to involve double-taxation (after-tax contributions which are taxed again as ordinary income when withdrawn) which would nonetheless benefit lower-income savers if the “credit” is higher than the tax they’d pay, but would cause higher earners to move into Roth accounts. (See “Joe Biden Promises To End Traditional 401(k)-Style Retirement Savings Tax Benefits. What’s That Mean?” and “Confused About Biden’s Tax Plan For Retirement Savings? An Actuary-Splainer About 401(k) Taxation.”)

That being said, let’s look at some recent reporting:

Catherine Brock, The Motley Fool, September 14, 2020, “Will Biden’s Proposed Changes to 401(k) Tax Rules Affect Your Retirement Plan?”

Jane the Actuary Seal of Approval? Not even close!

Brock writes,

“To understand what that means, it helps to revisit how those tax benefits work today. Under current rules, your 401(k) contributions are made with tax-free dollars. The amount you save by not having to pay taxes on those contributions is dependent on your tax bracket. If you are in the 22% tax bracket, you save $0.22 for every $1 you contribute. But if your marginal tax rate is 37%, you save $0.37 for each $1 contributed.”

No, no, no. The tax collector will indeed come for that money, just not now.

When one deducts charitable contributions, for example, from one’s taxes, it is a “true” deduction. But a 401(k) plan is entirely different, because it’s a tax deferral rather than a deduction.

Brett Arends, MarketWatch, Sept. 15, 2020, “Will Biden’s 401(k) plan help you or hurt you?”

Jane the Actuary Seal of Approval? Trying harder, at least.

“Right now you can deduct your contributions to your 401(k) plan right off the top of your income. So far as the IRS is concerned, the money is invisible for this year’s calculations. Make $200,000 and contribute the maximum $19,500 to your 401(k), and as far as Uncle Sam (and your state) are concerned, you didn’t make $200,000 this year, you only made $181,500.

“The more tax you pay, the more this saves you. If you have to pay the top, 37% federal tax rate on every extra dollar you earn, deducting that money from your tax return saves you $7,215 in income taxes. But if you’re only paying 10% federal tax on each extra dollar you earn, deducting $19,500 would save you just $1,950.”

The phrase “invisible for this year’s calculations” gave me hope that Arends would address the fact that the taxes are indeed paid at the back end, but no such luck, though he does acknowledge that “In practice, of course, most of those would simply get around the maneuver by changing their contributions from ‘traditional’ to ‘Roth.’”

Alicia Munnell, MarketWatch, September 14, 2020, “Biden’s 401(k) plan: Changing tax incentive for retirement is a great idea.”

Munnell is the director of the Center for Retirement Research at Boston College, so she knows her stuff. But does she communicate it to an audience that doesn’t?

Jane the Actuary Seal of Approval? Still falling short.

“Employers and individuals take an immediate deduction for contributions to retirement plans and participants pay no tax on investment returns until benefits are paid out in retirement. . . .

“If a single earner in the top income-tax bracket contributes $1,000, he saves $370 in taxes. For a single earner in the 12% tax bracket, that $1,000 deduction is worth only $120.”

Ugh. Again, taxes on contributions are deferred in a manner that has the effect of eliminating taxes on those investment earnings. A top-bracket earner doesn’t “save $370”; he defers that taxation and saves the investment return-taxes plus whatever amount the future taxes are lessened due to lower income in retirement.

Munnell does then, quite helpfully, cite research which, if its conclusions are borne out by other data, shows that tax incentives have no significant effect on retirement savings, but that auto-enrollment and other means of making saving automatic have a much larger effect. Whether her desire to make this larger point within a constricted word limit lead to her choices in explaining 401(k)s, I can’t say.

Timothy Carney, Washington Examiner, September 14, 2020, “Joe Biden won’t admit it, but his proposal would hike taxes on the middle class.”

Jane the Actuary Seal of Approval? Yes, then no.

“Under current law, income you put in your 401(k) retirement account today doesn’t get taxed until you can actually touch it— which is at retirement, at 59 and a half years old. It’s not a tax deduction like the deductions you get for health insurance and mortgage interest, as much as it’s a tax deferral. You will pay taxes on that income, but not until you get your hands on it and can spend it.”

So far, so good. But then Carney works out some math to prove that even average earners would be hurt under the Biden proposal, and he flubs it, comparing the value of the potential tax credit to the lost benefit of the tax deferral, but calculating it as if it were a true deduction instead.

 

December 2024 Author’s note: the terms of my affiliation with Forbes enable me to republish materials on other sites, so I am updating my personal website by duplicating a selected portion of my Forbes writing here.