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One of the more controversial elements of the proposal to “repeal and replace” the Affordable Care Act (ACA), introduced by House Republicans March 6, 2017, is the repeal of the ACA 3.8% Medicare Net Investment Income (NII) tax.
In this article we briefly discuss how that change, if enacted, would, for certain high-earners, reduce the relative value of saving in a 401(k) plan vs. saving outside the plan. We begin with a discussion of how the NII tax currently works and how it affects the (relative) value of 401(k) plan savings and then discuss how its repeal would reduce the value of those savings. (While, in this article, we illustrate tax effects with respect to 401(k) plans, the analysis provided applies to all tax-qualified plans.)
Medicare Net Investment Income tax and the relative value of 401(k) plan savings
As we have discussed (see our article A note on the retirement savings tax benefit ), assuming an individual’s tax rate is the same at the time of contribution and distribution, the tax benefit provided by saving in a tax qualified plan (e.g., in a 401(k) plan) is, and is only , the tax-exempt trust earnings. That benefit is, therefore, equal to the tax that would otherwise be paid on investment earnings outside the plan. (Where the tax rate at the time of contribution and distribution is different, there is also the possibility of a tax benefit from shifting income to a lower tax rate year.)
Currently, the tax on investment earnings (capital gains and dividends, but not interest) depends on the individual’s tax bracket: taxpayers in the 10% and 15% brackets pay no capital gains/dividends taxes; taxpayers in the 25%-35% brackets pay at a 15% rate; and taxpayers in the 39.6% bracket pay at a 20% rate.
For certain taxpayers (e.g., joint filers with adjusted gross income over $250,000), the 3.8% Medicare NII tax is added to capital gains and dividend taxes. So, e.g., taxpayers in the 39.6% tax bracket generally pay a 23.8% tax (20% capital gains and dividends taxes and 3.8% Medicare NII tax) on investment income.
Current value of 401(k) plan savings for a high earner
With that background, let’s consider the value of saving in a 401(k) plan vs. saving outside the plan, for an individual in the highest tax bracket who is also subject to the Medicare NII tax.
The following table shows the tax savings resulting from saving $18,000 (the maximum elective deferral for 2017) inside a 401(k) plan vs. saving the same amount outside a 401(k) plan, based on the given assumptions.
| Assumptions | |
| Contribution | $18,000 |
| Earnings rate | 3% |
| Years in plan | 10 |
| Income tax rate at contribution | 39.6% |
| Capital gains and dividend tax rate | 20% |
| Income tax rate at distribution | 39.6% |
| Medicare NII rate | 3.8% |
| Value of in-plan savings | $982 |
The additional value here – the $982 more that a 401(k) plan saver will have after her benefit is distributed than if she had saved outside a plan – results entirely from the investment tax exemption 401(k) plan savings enjoys. For this taxpayer, those taxes are at the highest rate – 23.8%.
Effect of repeal of Medicare NII tax on the value of 401(k) plan savings for a high earner
The repeal of the Medicare NII tax will reduce the investment taxes this individual is paying and will therefore reduce the relative value of saving in a qualified plan.
The following table compares current tax savings to tax savings after the repeal of the Medicare NII tax.
| Assumptions | ||
| Contribution | $18,000 | |
| Earnings rate | 3% | |
| Years in plan | 10 | |
|
|
Replace |
|
| Income tax rate at contribution | 39.6% | 39.6% |
| Capital gains and dividend tax rate | 20% | 20% |
| Income tax rate at distribution | 39.6% | 39.6% |
| Medicare NII rate | 3.8% | 0% |
| Value of in-plan savings | $982 | $829 |
Thus, the repeal of the Medicare NII tax reduces the relative value of in-plan savings by (on these assumptions) $153 or around 15%.
We will continue to follow this issue.