Tax Reform Could Spell Trouble for Employer-Sponsored Plans

At the 401(k) SUMMIT in San Diego, California, Graff said the Bush reelection and strong Republican gains in Congress lead to the perception of a mandate in Washington, which usually leads to big picture reform. Graff guessed that although Bush has been pushing a Social Security reform agenda, the reform more likely to suceed this term is fundamental tax reform, and this, Graff warned, could have huge implications for retirement plans.

Major tax reform could be “potentially disastrous to the employer-based retirement plan system,” Graff said, because it could eliminate incentives for employers to offer retirement plans. President Bush established an Advisory Panel on Federal Tax earlier this year and asked them to recommend ways to simplify the federal tax code. The Panel’s report is to be delivered by July 31, 2005 and Graff suggested two possible approaches that could be discussed in the report: the consumption model and the simplification model. The consumption model is similar to a national sales tax while the simplification model allows for rates to be flattened and greatly reduces the number of itemizers, similar to tax reform seen in 1986.

Each model has its own negatives, according to Graff. The consumption model eliminates an income tax, and therefore eliminates many of the incentives currently offered by a qualified plan, notably the ability to shield gains from immediate taxation, as well as the benefits of tax deduction to the employer.  The simplification model, contrarily, could result in the elimination of the tax on capital gains and dividends on after-tax investments, which could result in enhanced incentives for nonqualified investments that would also make such investments more attractive than a retirement plan for some business owners.

Graff hypothesized that the simplification model is more likely to be proposed because he does not see a national sales tax being attractive to many on Capital Hill.   The consumption model could create complicated transition rules, and would especially be problematic for retirees for whom the added taxes could eat up their savings, he said. However, the simplification model could reflect the “consumption approach,” Graff suggests by eliminating or reducing the taxes currently levied on investment income.   This approach could have a huge impact on employer based retirement plans because only investments outside of qualified plans would be taxed. This would eliminate the tax advantages of qualified plans, because it eliminates the incentive for long-term savings and makes short-term savings more favorable because there are no limits on access to the money.

Another problem this causes is the incentive not just to invest in a qualified plan, but also to offer a retirement plan though the workplace. According to a survey by the Employee Benefits Research Institute (EBRI) in 2003, employer sponsored retirement plans are necessary to promote retirement saving among middle income workers. The survey showed that when offered a plan through the workplace, 77.9% of Americans earning annual salaries of $30,000 to $50,000 invested in the plan, but of those same income Americans not offered a retirement plan, only 7.1% of them invested in an IRA. This presents issues if the incentive to offer such plans is erased because it is unlikely that middle Americans will be disciplined enough to save for the long-term without the built in restrictions of long-term savings vehicles.  The point, one made in previous years by Graff, is that without the convenience and incentive afforded by workplace programs, American workers appear to be unwilling to make the committment to long-term retirement savings.

Although workplace savings plans are necessary to increase retirement savings, if the simplification tax reform model were to eliminate taxes on capital gains and dividends, business owners might choose to simply invest their personal money and not offer a retirement plan, because the tax consequences of personal savings would no longer be a factor. For obvious reasons, Graff suggests, employers would be more likely to buy mutual funds on their own than endure the ERISA liability and required testing incurred when offering a workplace qualified plan.  This disincentive concern has been raised previously by opponents of President Bush’s proposed Retirement Savings Accounts and Lifetime Savings Accounts, which some see as attracting the interest of small business employers in place of an emloyer sponsored model.  

ASPPA is forming a commission to ensure that any tax reform retains an appropriate level of tax incentives for qualified retirement plans. It is important to the qualified plan system that tax reform encourage retirement policy and long-term savngs because increasing savings rates in the aggregate at the expense of long-term savings rates by low-to-moderate income workers will be detrimental to the economy in the long run, Graff explained.

Additionally, Social Security reform will go by the wayside mostly because it is not necessary yet, said Graff, citing that the outlays of the system will exceed payroll tax in 2042. Congress has never acted on something 37 years in advance, Graff observed, and says he does not expect this will be the issue on which they do so. It is unclear whether Social Security reform will ever reach the Senate floor, he said, because Senate Democrats appear to be solidly opposed to the possibility of borrowing required to fund the program that those Senators have labeled “immoral.” Additionally, the House leadership won’t act until the Senate acts, which makes it even more unlikely we will see much more action on the proposals, Graff predicted, although ASPPA will be focused on assuring that whatever proposals are put forth do not diminish the incentives for saving in workplace retirement plans.