Tax Reform Takes Center Stage
With health care reform off the table (at least for the moment), Congress will now turn to… tax reform.
Over the weekend, House Ways & Means Committee Chairman Kevin Brady (R-Texas) said he aims to move a tax reform bill through his committee this spring. According to Reuters, Brady said he intends to have the House bill serve as the blueprint for President Trump’s tax reform bill rather than negotiating between competing plans from the Treasury Department and the White House.
That House blueprint pledges to “continue the current tax incentives for savings,” but also directs the Ways & Means Committee to “consolidate and reform the multiple different retirement savings provisions in the current tax code to provide effective and efficient incentives for savings and investment.” So while the current retirement savings vehicles – like the 401(k) — will not be removed from the tax code under the House Republican plan, those vehicles could be combined into one “cookie cutter” approach.
Brady has previously invoked the spirit of the Tax Reform Act of 1986 as a model — a basis that should be of concern to those interested in encouraging retirement savings. Along with the changes in corporate and individual rates, at that time the 401(k) deferral limit was capped at $7,000, greatly diminishing not only the ability of individuals to save for retirement, but the incentives for those who decide to establish and maintain these programs for others. We’re talking about things like tightening the nondiscrimination rules, reducing the maximum annual 401(k) before-tax salary deferrals by employees by 70%, and requiring that all after-tax contributions to DC plans be included as annual additions under the Code Section 415 limits. And what did all that do for — or rather to — retirement savings?
Yes, for all the concerns expressed by those in our nation’s capital, tax reform is all about reducing the amount of revenue that the federal government takes in. But with a $20 trillion debt, Uncle Sam will need to find some way to offset the projected loss in revenue – and that’s where the tax incentives to establish, fund and contribute to a workplace retirement plan inevitably find themselves in the budgetary crosshairs.
While those paying attention to such things realize that most of those tax preferences are temporary – that is, taxes will be paid on those employer and pre-tax contributions and the earnings thereon when they are withdrawn — the government beancounters look at revenues and expenditures within a 10-year window, and since the payment of most retirement benefits occurs outside that window, the amount of taxes postponed looks, from a budgetary standpoint, to be taxes permanently foregone. And on that basis, even though the retirement preferences are completely different from other tax deductions, from a budgetary scoring standpoint, it’s a big, juicy target.
We saw what that might mean as recently as 2014 when then-Chairman of the House Ways & Means Committee Rep. Dave Camp (R-Mich.) put forth a proposal that would pay for tax reform (or at least some of it) by freezing the COLA limits that apply to defined contribution plans for a decade and limiting the annual ceilings on elective deferrals so that only half could be made on pre-tax basis (weirdly, this would have applied only to employers with more than 100 workers). The first part of the proposal was deemed to raise $63.4 billion in revenue over 10 years, the latter an additional $144 billion, by basically forcing workers who would otherwise have taken advantage of pre-tax savings to pay taxes on those contributions upfront. And let’s not forget that those burdens would have fallen particularly harshly on those who decide to offer these plans in the first place and to match employee contributions.
As it turns out, the House Blueprint for tax reform provides a 25% tax rate on income from pass-through entities (partnerships, S corps and small business limited liability corporations). In addition, earnings on pass-through income receive a 50% exclusion under the plan, but under that same Blueprint, retirement distributions are subjected to ordinary income tax rates – and for many successful small business owners, even under tax reform, that could be a 33% tax rate; income that is contributed to a qualified retirement plan for business owners rather than passed through to business owners at 25% tax rates. If the Blueprint is enacted in its current form, these small business owners will take a big financial hit if they defer their current income into a retirement plan.
So, while tax reform might provide some important benefits in some areas, it could also work to undermine key incentives to establish, support and contribute to workplace retirement plans.
Speaking at an event in Washington on March 24, Treasury Secretary Steven Mnuchin said that overhauling the tax code – which hasn’t been done since 1986 — should prove easier than the effort to repeal and replace the Affordable Care Act. “Health care and tax reform are two very different things,” Mnuchin said. “Health care is a very, very complicated issue. In a way, [tax changes are] a lot simpler. It really is.”
And yet, potentially no less disruptive.