Monday, August 5, 2019

Even Out the Tax Benefits for All Workers Saving for Retirement

Even Out the Tax Benefits for All Workers Saving for Retirement
We are awash in big news these days. Right after reaching the milestone of paying off our mortgage we found out we maybe, technically might have achieved the goal this blogger set out to accomplish way back in 2012: being financially independent according to the 4% rule.

With all that still fresh in the air, last Friday Mrs. Done by Forty accepted a full time post-doc position to begin when we return from a trip abroad. She'll get to work in her field, and locally, too: two things we never thought would be possible at the same time when she entered the PhD program.

Her new job will bring on some changes, which we're going to tackle in our first ever collaborative post in the coming weeks.

But today I wanted to talk about one big change that's going to occur specific to our financial independence plans: Mrs. Done by Forty will have an employer-sponsored retirement account for the first time in over a decade.

Ever since Mrs. Done by Forty entered her PhD program back in 2009, she hasn't had an option to contribute to a 401k (or the government equivalent, a 403b). So while she was earning income as a research assistant or teaching assistant each year, about $18,000, she couldn't shield that income from income taxes like workers with a 401k could. All she could use was an IRA, which could shield only $5,000 from taxes when she first started, recently upped to $6,000.

On top of that, the university chose not to pay Social Security taxes for their student workers, so Mrs. Done by Forty didn't even earn credits towards her Social Security during this entire decade. This means she avoided paying those taxes ($1,116 per year on $18,000 of income), but despite working & earning income through her PhD program, she wasn't contributing towards the 40 credits required for Social Security benefits.

But back to the retirement options she did have available to her. Mrs. Done by Forty could shield between $5,000 and $6,000 for each year she worked into an IRA.

This tax benefit is the federal government providing a subsidy for a behavior they want citizens to engage in: saving for their retirement.

But workers who have an employer sponsored plan, usually a 401k, get a much larger subsidy from the federal government: $19,000 can be deferred from any federal income taxes & allowed to grow tax free, until withdrawals in retirement. On top of that, many employers provide a percentage match on top of this, which is also not taxed until retirement. In addition to this much larger subsidy, these workers also have the same IRA options available to them, depending on their income. If workers MAGI is $64,000 or less, they can deduct another $6,000 from their taxable income, on top of their 401k deductions, by contributing to both an IRA and a 401k.

Simply put: the federal government gives a tax subsidy three or four times as large to workers whose employers offer a 401k or 403b than they do to workers who don't. It's a tax break, and one that ends up being regressive in nature: workers who earn more get more tax benefits.

This seems patently unfair. Workers whose employers can't or won't provide these sort of benefits, and those who earn less, are more in need of tax incentives. But it's the highest earning workers with the best benefits who, well, benefit the most.

With her new job though, the tables have turned. Mrs. Done by Forty now has a unique retirement benefit, the 457b, which are usually for state & local government employees, but there are some non-government options available to non-profits & hospitals. This 457b plan is available in addition to a 403b retirement plan.

We're already diving too deep into the tax code for a Monday morning, but the bottom line is that Mrs. Done by Forty will now have the fairly remarkable but utterly unfair option to shield not just $19,000 from federal income taxes, but up to $38,000, because she has two different employer plans she can contribute to as a government employee. And she can still contribute $6,000 to a Roth IRA if she wants, for even more tax free growth.

That's an amazing $44,000 that's getting some sort of tax advantaged treatment from the federal government, but $38,000 of annual income that is deferred from federal income tax each and every year she works this job.

Compare this to a worker without an employer sponsored plan: who gets only $6,000 that can be shielded from taxes.

The funny thing is that we know several government employees who have both of these retirement accounts available to them and literally not one of them has been able to max out both the 457b and 403b accounts even once. It's just not all that reasonable for the average person to try to put $38,000 into her retirement accounts in one year on a government employee's income.

But you know who can try something like that? FIRE folks can: we weirdos with the nonsense savings rates.

You know who else might be able to take advantage? A couple that has one person working in government with this unique, double retirement account option that no one else has (but maybe a smaller salary), while the other person in the couple works at a higher paying job in the private sector.

Mrs. Done by Forty and I happen to be both of those people. Next year we're going to be able to shield something like $57,000 from federal income taxes if we want to in just our retirement accounts, while very, very few other people in the country will be in a position to do so.

I'm not sure that subsidizing the early retirement of high earners was what the government had in mind when they created this tax system.

It's just weird to look back on Mrs. Done by Forty's past decade of work and see such varied benefits being doled out to her by the federal government. She's the same person, doing primarily the same sort of work at the same institution. For the last ten years, Uncle Sam gave her the minimum incentives to save for retirement: avoiding taxes on five or six thousand bucks. Now he's about to give her over six times as big of a tax deduction, just as her income increases and she technically should be paying more in tax in a progressive system.

But she'll have less taxable income, and thus pay less in income tax on her wages, earning $50,000 a year, than she was when she was making $18,000.

This a very bad system.

A better approach would seem to just give all workers the same options for tax breaks, regardless of where they work. That is, if a worker has a 401k, 403b, or 457b available to them, they can pick whatever one they like, but then the the total amount they could defer from taxation was the same: $19,000.

(If this sounds too simple, that's because this is what the tax law used to be until the Bush era tax cuts, that aimed to create an Investor Class, went into effect back in 2001. This tax cut, in addition to doubling the federal deficit over time, now allowed workers with multiple retirement accounts max out both a 457b and a 401k/403b, essentially doubling their tax advantages. The tax cut laws were set to expire under the Obama administration, but the Great Recession and the GOP regaining control of the House in 2010 ensured they would remain.)

Regardless of how we feel about certain workers getting too many retirement accounts, a more dire situation is seen with workers who don't get great benefit packages, yet are also denied equal tax advantages when saving for retirement. The share of workers who are contractors, not employees, is growing. And in addition to these contractors typically not getting health benefits, paid time off, or vacation days, many of them do not have employer sponsored retirement plans like a 401k.

It seems patently unfair that the workers with the least generous benefits, or no benefits at all, also have to deal with getting the fewest tax benefits from the federal government as well.

While we probably can't force employers to spend the shockingly paltry amount of money it takes to set up a 401k for workers, there's no reason the government cannot offer the same tax incentives to all workers. For employees who don't have a retirement account with their employer, the contribution limit for the Traditional IRA limit should be increased to match that of a 401k: $19,000 annually. (Or for workers with MAGI below $64,000, it should be set to $25,000, equaling the tax deferral available to workers with a 401k and the option to put $6,000 in a Traditional IRA).

In addition, such workers without a employer sponsored retirement plan should be able to also contribute to a Roth IRA, just like workers with a 401k can.

I'd like to think that none of this would be controversial. I just think that all workers should get the same tax breaks, the same incentives, to do something we want all our citizens to do: save for retirement. It doesn't make a lot of sense to me to give some high earning workers a lot of tax breaks, and then turn around and give other workers hardly any at all.

And with a higher and higher share of our workers trending away from traditional employment and towards being independent contractors, there's going to be a greater need for that kind of policy.

As always, thanks for reading.

*Photo is from Got Credit at Flickr Creative Commons.

**As always, nothing on this blog should be considered tax, investment or any other kind of of advice. Work with a professional for figuring these things out.
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  1. Wow, congratulations! The 457 plan sounds like a great additional benefit. That's a huge amount to help with taxes.

    1. Thanks, Joe!

      The 457 is a great benefit but I feel conflicted about us being the family that gets it & can actually take advantage of it in addition to a 403b & 401k. We're definitely not the family who should be getting tax breaks.

  2. I agree in giving everyone the same tax break limit. However, I do wonder if it is better for the lower earners to simply by ETF's with after tax money. The ETF's will tax earnings, but the dividends are small for ETF's and the tax rate on qualified dividends are zero up to some pretty high levels. All this to say that the bigger problem may not be the tax code, but getting people to live below their means (i.e. save) in the first place.

    1. That's a good call out, Greg. For low income people, additional tax deferral is no help at all.

      I think a small tweak would be to increase the amounts for IRAs as well as Roth IRAs to those higher figures: allowing for those at a low tax bracket to get Roth advantages if they want.

      And I believe everyone can already buy no-fee ETFs in a Roth or Traditional IRA if they want with places like Vanguard or Fidelity.

      But you're right: the big problem is insufficient income for people to create enough surplus to invest much in the first place. The underlying issue really is that we don't pay many Americans enough to save for retirement. Raising wages for the bottom quintiles is going to be part of any systemic solution.

  3. Another benefit of the 457 plan is that there is no penalty for early withdrawal before age 59 1/2 like with the 401K. It is definitely an added benefit for someone on the path to FIRE!

    1. That's a good point, Andrew, and one I left out of the post.

      Yet another advantage of the 457!

      I think I feel some guilt for getting this rare benefit when we're really not the family the government ought to be subsidizing. We're benefiting from a loophole in the system designed by the GOP.

  4. I will always say that our system is designed to benefit those savvy and well connected. The rest need to fend for themselves. I guess in some respects these big companies need some means to incent talent, but it results in some high disparities in income -- take for instance employee stock buy back programs. Not an option at WalMart.

    1. Hey there, Cubert!

      Agree, the system seems slanted in favor of those who are in the know (and, of course, those with the income and wealth at their disposal to take advantage of that knowledge).

      And yeah, we get the ESPP, too: yet another neat part of my already too-high compensation.

      Like you said, at Walmart (the nation's largest employer, I believe) their average employee isn't able to fully fund even one retirement plan, let alone, two. I think I'm having trouble coming to terms with that disparity.

  5. Hey, Mr. DBF. A great post. Congrats to Ms. DBF - looking forward to the joint post!

    You're absolutely right, the system is built to benefit the highest earners in this case. Difficult to be able to put $44K (457+403b+IRA) away unless you're making well above the US median household income (~$61K) - even if you're quite frugal. I also happen to know from informal surveying that not a single individual I spoke with making over $100K even knew about the 457, and weren't even maxing their 403b.

    I say, Senor DBF, you take full advantage and sleep well knowing how few people can and do use it.

    In the end - all added onto the pile of ridiculous blessings. Cheers!

    1. Hey there, buddy! Thanks for stopping by.

      Yeah, your point about government workers not taking advantage of the 457 is interesting. I think in some cases (like those making over $100k) then it's just a matter of choices or information.

      But for the average government employee, I don't see how they're going to sock away $38k or $44k on the median employee income. I think usually partner/spousal income is how people, if they're going to max both, make it happen.

  6. Yay for you both!

    I'm in the same position that Mrs DbF was in for nearly the same amount of time as well and it totally sucks because even if I couldn't have maxed out $19K, I could have at least tried to get nearer to it, over $6K. I'm investing really heavily now to make up for lost time but nothing will make up for the lack of tax benefits.

    1. Yeah, those years of lost tax benefits (AND the loss of any Social Security contributions) is pretty harsh. I think it's a travesty that the university can get out of paying those SSI taxes.

  7. I too got a PhD and understand the position Mrs. DbF is in. I am the rare exception of doing the max $44k plus the university retirement plan that matches my contributions (One uni was me 10%, they match at 13% (though no social security) and the other is me 5.5%, match 7.5% (with social security)) So it really ends up being more than $44k that a person can contribute! I am doing this all as as a single person too. I lived a great life full of joy and happiness on my graduate student stipend and every pay raise after that has gone straight to retirement. Buying more "stuff" with my raise I knew would not bring me an equal amount of more happiness. I rather save to buy my time back! (My time is my most precious gift I think)

    1. That's great that you're able to take full advantage of the accounts available to you. And a 13% match! Wow, that is just incredible: what a benefit.

      I really like the way you've framed the decision to purchase time or stuff. I think for those of us with significant disposable income, that's really the way to frame it.