Barry’s Pickings Online: Stakes for Retirement Savings in Tax Reform

Michael Barry, president of the Plan Advisory Services Group, discusses what is at stake for retirement savings in tax reform.

Art by Joe Ciardiello

Art by Joe Ciardiello

On September 27, Republican leadership introduced its “framework” for comprehensive tax reform. Billed as a “once in a generation” opportunity, the proposal is producing the expected heated controversy over everything from the elimination of the estate tax and corporate tax cuts to the elimination of the individual deduction for state and local taxes.

How would this proposal—if it were to pass—affect retirement savings policy?

Let’s start with the good news.

Under the proposal, the highest marginal corporate tax rate would be reduced from 35% to 20%, and corporations would be allowed to immediately write-off new investments in depreciable assets. Lower corporate taxes will increase returns to all investors. Critically, however, the increase in returns will be greater for investors holding stock in tax-qualified plans.

The logic here is relatively straightforward. Individuals holding stock outside a plan will pay taxes at the capital gains/dividend rate on those higher returns. That tax on investments is not (at least as the proposal now stands) changing. For the highest paid, the tax rate on investments is 23.8%. Individuals investing in stock in a tax-qualified plan will not be paying that tax. From there the math is pretty simple—higher (non-taxed) returns = higher tax savings (relative to non-plan investors).

I estimate that an individual saving $18,000 in a 401(k) plan at a (current) rate of investment return of 4% for 10 years saves around $1,400 versus an individual investing the same amount outside a plan (and paying taxes that the in-plan investor does not pay). If that rate of return (as a result of the lower corporate tax rate) increases to 5%, the in-plan investor earns around $1,900 more than an outside-the-plan investor. So the tax-efficiency of saving inside a plan improves (in this example) by $500 or 36%.

Just to be clear, this tax savings is a function of the tax rate on investments, which under the proposal is not changing. The change in income tax rates does not affect this calculation.

Two caveats: First, some (all?) of this increase in returns may either already have been priced into the market or after the legislation is passed, be reflected in a one-time write-up in the value of assets already held in qualified plans. Second, the reduction in corporate taxes will not fall evenly—for instance, not all firms will be able to write off substantial depreciable assets, and the proposal includes a partial limitation on corporate interest deductions.

How are they going to pay for this?

It’s unclear how Republican policymakers expect to make up for revenue losses from the reduced corporate rate and lower individual tax rates. It looks like the plan is to leave the details—and many of the difficult policy tradeoffs—to the committee process.

There is widespread concern that the Republicans will turn to retirement savings policy to make up any revenue shortfall. In this regard, three areas are of concern.

Rothification: At this point, enough ink has been spilled on the cons and pros (if there are any) of requiring that employee 401(k) contributions go in on a post-tax (Roth) basis. Suffice it to say that switching taxation of 401(k) contributions to the front end produces a lot of revenue—more than $500 billion over 10 years—making it a very sweet target.

Democrats and the retirement savings community are pushing back on this issue. There is likely to be a fight over it, and the result, like much with respect to this legislation, is likely to depend on the attitude of a handful of swing Republicans in the Senate.

In the end, however, Rothification may simply be the price that corporate America has to pay for a lower corporate tax rate.

Defined benefit (DB) plan funding: In the last five years, policymakers have used reductions in DB funding requirements and increases in Pension Benefit Guaranty Corporation (PBGC) premiums to fund two separate (and semi-massive) highway bills and to plug a hole in the 2015 budget. Towards the end of that period even those policymakers were admitting that they were going too far—although, sadly, that self-awareness did not stop them from doing it. PBGC premiums and the revenue generated by reduced DB funding are just too easy a way to raise revenues without taxing anybody—except the DB system. Which most agree is unraveling as sponsors look for ways to get out of those ever-increasing PBGC premiums.

The money at stake here is nothing like the revenue gain from Rothification, but when they get down to the short strokes it may—conceivably at the very last minute—be the only way to produce the final $10-$20 billion of revenue needed to make tax cuts look responsible.

Tweaks: There are a number of smaller revenue-producing retirement savings items that Congressional tax-writing committees have been considering. A massive tax overhaul is likely to include at least some of these, e.g., elimination of “stretch” payouts from individual retirement accounts (IRAs) and DB and defined contribution (DC) plans, elimination of the employee stock ownership plan (ESOP) dividend deduction, and enhancement of the ability to do in-plan Roth conversions.

What about some basic retirement savings policy improvements?

In 2016 the Senate Finance Committee unanimously approved legislation that would make a number of improvements to the current system, including providing a path forward for open multiple employer plans (MEPs), fixing the DC annuity fiduciary safe harbor, addressing the nondiscrimination issues presented by closed groups, and requiring lifetime income disclosure in DC plans. There have also been proposals to enhance the 401(k) safe harbor rules that have received strong bipartisan support.

Whether some or all of these items may be included in tax reform is an open question. A critical issue is the extent to which they can be included in Reconciliation legislation under the budget rules.

All of which is to say that there will be a lot at stake for us in this process. And it could go either way. Watch this space.

Michael Barry is president of the Plan Advisory Services Group, a consulting group that helps financial services­ corporations with the regulatory issues facing their plan sponsor clients. He has 40 years’ experience in the benefits field, in law and consulting firms, and blogs regularly about retirement plan and policy issues.


This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Asset International or its affiliates.