On February 26, 2014, Congressman Dave Camp (R-MI), Chairman of the House Ways and Means Committee, released a ‘discussion draft’ of the Tax Reform Act of 2014 (TRA 2014), a comprehensive revision of the Tax Code.
In this article we review TRA 2014 proposals that would change the tax treatment of retirement savings, discuss how proposed changes to tax rates might affect the incentives for individuals to save for retirement, and consider the politics of this proposal.
Provisions of TRA 2014 affecting retirement plans
Here are, as we understand it, the provisions of TRA 2014 that would significantly affect retirement plans:
Except for certain plans of small employers (100 employees or less), the dollar limit on ‘pre-tax’ 401(k) contributions would be reduced by one-half. Thus, based on 2014 limits, under the proposal the limit on pre-tax contributions would be $8,750 (one half of $17,500), and the catch-up contribution limit would be $2,750 (one half of $5,500). Current limits would remain in place for the combination of pre-tax and ‘Roth’ contributions – an employee could still make the maximum 401(k) contribution but half of that contribution would have to be made on a Roth basis. (See below for a discussion of the difference between pre-tax and Roth contributions.)
401(k) plan sponsors would generally be required to include a Roth contribution option in the plan (there would be an exception for certain small employer plans).
The dollar limits on qualified plan contributions and benefits would not be adjusted for inflation for the period 2015-2023.
New rate structure and taxation of pre-tax DC contributions
For taxpayers with income over certain dollar thresholds there would be a tax on pre-tax contributions to defined contribution plans. How this tax works is a little complicated, as the pre-tax contribution is embedded in the tax calculation via a ‘phase-out’ and a ‘surcharge’ calculation.
‘Regular rates.’ TRA 2014 proposes two ‘regular’ tax rates: 10% on taxable income up to $71,200/$35,600 (joint/individual filers); and 25% on taxable income above that number.
Additional phase-out and surcharge on higher income taxpayers. Higher income taxpayers are subject to two additional taxes.
First, there is a ‘phase-out’ of the lower 10% tax rate on the first $71,200/$35,600. Generally, the point of this phase-out is to make any taxpayer making over $513,600 pay a 25% (rather than 10%) tax on the first $71,200/$35,600. This phase-out is ‘phased in’ as an additional tax of 5% on modified adjusted gross income over $300,000/$250,000.
Second, there is a ‘surcharge’ of 10% on modified adjusted gross income over $450,000/$400,000.
Unlike the ‘regular rates’ (10%/25%), which are calculated on ‘taxable income,’ the phase-out and surcharge taxes are calculated on modified adjusted gross income (MAGI). To get MAGI you add back in to income certain tax preferences, including certain tax exempt interest, excluded employer-sponsored health coverage, deductible health savings account contributions, and pre-tax contributions to tax-qualified DC plans. Pre-tax DC contributions include not just employee pre-tax 401(k) contributions but also, e.g., employer nonelective and matching contributions. Adding these tax preferences back in to income for purposes of the phase-out and surcharge taxes works something like the Obama Administration’s proposal to cap deductions for certain tax preferences.
The operation of the phase-out is complicated. Here is our best shot at describing how it applies to pre-tax DC contributions: Based on a pre-tax DC contribution limit of $52,000, for joint filers, there is no phase-out tax on a pre-tax DC contribution if the participant’s AGI plus tax preferences other than the DC pre-tax contribution are either (1) no greater than $248,000 or (2) greater than $513,600. In between those numbers, there is generally a 5% tax on DC pre-tax contributions to the extent they push MAGI over $300,000 but not over $513,600.
The surcharge is (slightly) easier to explain. Under the surcharge, an additional 10% tax is imposed on all DC pre-tax contributions to the extent the taxpayer’s MAGI exceeds the $450,000/$400,000 threshold.
This is all, obviously, a little confusing – taxpayers may be forgiven for thinking that these results are neither simple nor particularly intuitive. At the end of this article we work through some examples illustrating how these tax rates would apply to pre-tax DC contributions at different income levels.
A disincentive to DC benefits. The additional taxes paid on pre-tax DC contributions (both the 5% phase-out and the10% surcharge) don’t (apparently) add to ‘tax basis’. So the participant pays tax on these contributions going in and going out. While, for employee contributions, switching to Roth contributions may be a way around paying these extra taxes on ‘pre-tax’ DC contributions, the Roth contribution rules do not apply to employer contributions – e.g., an employer match or nonelective contribution. Employer contributions are always pre-tax. Thus, the phase-out and surcharge significantly reduce the value of DC benefits to high paid employees. For those employee-taxpayers, a DB plan would have more appeal.
Roth vs. pre-tax contributions. Roth 401(k) contributions are salary reduction contributions made out of after-tax pay. They generally accumulate in the 401(k) plan tax-free and are not subject to taxation on distribution. Assuming constant tax rates, paying taxes up-front, accumulating earnings tax-free, and not paying taxes on distribution is financially equivalent to a ‘regular’ pre-tax 401(k) contribution, where you defer taxation up-front but are taxed on distribution.
Data indicates that most participants prefer to make pre-tax contributions, rather than Roth contributions. This preference may, in part, be explained by behavioral economics – humans prefer the bird-in-the-hand of a current tax deduction/exclusion to the two-in-the-bush of future non-taxation. Another explanation may be that some participants generally anticipate lower tax rates in retirement, because of reduced income, so that the ability (available with pre-tax contributions but not available with Roth post-tax contributions) to shift taxable income from the current to a future period has real value. Thus, cutting pre-tax contribution limits in half may be perceived as (and in some cases may in fact be) a significant reduction in tax benefits.
Other retirement-related provisions
TRA 2014 also includes provisions:
Repealing the exemption from the 10% early distribution tax for first time homebuyers.
Eliminating stretch-IRA treatment (including ‘stretch’ payments under defined benefit plans). (We review this issue in our article Senators target ‘stretch’ payouts of retirement benefits for elimination.)
Allowing in-service benefit commencement in DB plans at age 59-½.
Eliminating the 6-month suspension rule for hardship withdrawals.
Extending the rollover period for loan offsets (in, e.g., a 401(k) plan for a terminating participant) to the participant’s tax return due date.
What does all this mean?
It’s hard to see how any of these proposals have much to do with retirement policy. They seem primarily designed to solve revenue problems presented by other provisions of Congressman Camp’s proposal (e.g., the reduction in marginal tax rates).
The provisions that incentivize Roth contributions/dis-incentivize pre-tax contributions ‘create” revenue simply because of the way Congressional budgeting works: Congressional budget ‘scoring’ only looks (at a maximum) 10 years out. Thus, for instance, the full cost to the Treasury of taxes lost on Roth 401(k) savings does not show up in current budget numbers.
The 10-year freeze on inflation adjustment of the dollar limits looks like a simple take-away of retirement savings tax benefits.
Capital gains tax rates would (more or less) be unchanged under Congressman Camp’s proposal. As we have written in the past, retirement savings tax benefits in effect ‘compete’ with income tax and capital gains (and dividend) tax treatment. Lower marginal income tax rates make tax-qualified retirement savings marginally less attractive. Halving pre-tax contribution tax benefits may be particularly problematic, given participants’ demonstrated preference for them.
Finally, as noted above, the phase-out and surcharge significantly reduce, for high paid employees, the value of DC benefits.
Adding all this up, TRA 2014 would significantly burden the DC system and make retirement savings generally marginally less appealing. It may, however, be a mistake to overthink these issues. TRA 2014 is, at this point, only a ‘discussion draft.’ Quite aside from the major (strategic) attacks on it that are already coming from special interests affected by the elimination of many current tax benefits, there will no doubt be a lot of (tactical) tweaking of its provisions.
One of the more interesting comments on Congressman Camp’s tax reform effort came from House Speaker John Boehner (R-OH), arguably Congressman Camp’s boss. When asked to comment on the tax proposal, Congressman Boehner said (among other things): “Blah blah blah blah. Listen, there’s a conversation that needs to begin. This is the beginning of the conversation.”
The retirement ‘policy’ provisions of TRA 2014 appear to be just another set of provisions designed to raise revenue for other (non-retirement) purposes. That is something like what happened with last year’s year-end budget deal.
Many (including, e.g., Senate Minority Leader Mitch McConnell (R-KY)) have said that TRA 2014 is unlikely to move in this Congress.
Below are examples illustrating the tax on pre-tax DC contributions. All examples are for joint filers.
Employee A makes $300,000. If he gets no DC contribution (and has no other tax preferences that would add to MAGI), he pays $64,320 in taxes: 10% ($7,120) on the first $71,200 of income plus 25% ($57,200) on income over $71,200. If, in addition, he gets a (pre-tax) $52,000 contribution to his employer’s profit sharing plan, he will pay an additional tax on that contribution of 5% ($2,600). That tax on the DC contribution is all from the 5% phase-out.
Employee B makes $600,000. If she gets no DC contribution (and has no other tax preferences that would add to MAGI), she pays $165,000 in taxes: 25% ($150,000) on all $600,000 plus 10% ($15,000) on income over $450,000. If, in addition, she gets a (pre-tax) $52,000 contribution to her employer’s profit sharing plan, she will pay an additional tax on that contribution of 10% ($5,200). That tax on the DC contribution is all from the 10% surcharge.
Employee C makes $450,000. If she gets no DC contribution (and has no other tax preferences that would add to MAGI), she pays $109,320 in taxes: (1) 10% ($7,120) on the first $71,200 of income; (2) 25% ($94,700) on income over $71,200; and (3) 5% ($7,500) on income over $300,000 (this last item is the phase-out). If, in addition, she gets a (pre-tax) $52,000 contribution to her employer’s profit sharing plan, she will pay an additional tax on that contribution of 15% ($7,800). That tax on the DC contribution is a combination of the 5% phase-out and the 10% surcharge.
The last example is as bad as it gets – at taxable incomes below $450,000 and above $461,600, the tax on the DC contribution is less than 15%. Below $450,000 the surcharge does not fully apply. A DC contribution may push a taxpayer over $450,000, and the surcharge will apply to that ‘pushed over’ part, but only that part. Above $513,600, the phase-out doesn’t apply, although the phase-out may still apply to the part of a DC contribution that is not over $513, 600.