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In this article we review the “framework” for tax reform released September 27, 2017, by Republican Congressional leadership and how it may affect retirement savings policy.
Quoting the document released by Republican leadership:
This unified framework serves as a template for the tax-writing committees that will develop legislation through a transparent and inclusive committee process. The committees will also develop additional reforms to improve the efficiency and effectiveness of tax laws and to effectuate the goals of the framework. The Chairmen welcome and encourage bipartisan support and participation in the process.
It appears that the Republican leadership’s strategy is to leave the development of details – and many of the difficult policy tradeoffs – to the committee process.
Generally, the framework states:
The framework retains tax benefits that encourage work, higher education and retirement security. The committees are encouraged to simplify these benefits to improve their efficiency and effectiveness. Tax reform will aim to maintain or raise retirement plan participation of workers and the resources available for retirement. (Emphasis added.)
With regard to retirement savings policy, it’s not exactly clear what this commitment “to maintain or raise retirement plan participation of workers and the resources available for retirement” may mean.
While proposing significant individual and corporate tax rate cuts, the framework does contemplate the elimination of a number of individual and corporate deductions – e.g., elimination of all itemized deductions other than home mortgage interest and charitable contributions and partial limitation of corporate interest deductions. It does not, however, directly address budget issues and any possibility of “revenue neutrality.” One of the first questions that will be raised about this proposal will be how much it will cost and how any revenue shortfall can be made up.
If – as seems likely – it becomes necessary to find ways to raise revenue to pay for tax cuts, then there is a real possibility that policymakers will look to changes in retirement savings tax policy for “revenue enhancements.”
In this regard, the big item is, as we discussed in our article on the issue, “Rothification” of the 401(k) contribution rules. Under the Rothification proposal currently being discussed by policymakers, employee 401(k) contributions would be taxed up-front (go in on a “post-tax” basis), and distributions would not be taxed. This proposal might include an exemption for, e.g., the first $2,500 of savings and be paired with additional incentives for low-paid employee savings, e.g., an enhanced Saver’s Credit.
It is also conceivable that Congress will, as it has in several recent pieces of legislation with respect to which it needed to “find revenues,” raise Pension Benefit Guaranty Corporation premiums and/or further relax defined benefit plan funding requirements.
Finally, there is a list of smaller retirement related revenue-raising items, including: elimination of “stretch” payouts from IRAs and DB and DC plans; elimination of the ESOP dividend deduction; and enhancement of the ability to do in-plan Roth conversions. Some of these issues may even come up in debates over “efficiency and effectiveness” and not just in debates over revenues and the budget.
We want to emphasize that none of these proposals – e.g., Rothification or PBGC premium increases or elimination of stretch payouts – is included in the framework. But if they do come up as part of an effort to raise revenues to pay for rate cuts, they will have a direct effect on retirement savings policy.
As we have discussed in the past, changes to individual and corporate income tax rates and in taxes on investments have an effect on the value of the retirement savings “tax deal” – the attractiveness of saving in a tax qualified plan.
We discuss the terms of the current retirement savings tax deal in detail in our article Retirement savings tax incentives – the current system. Summarizing, under current rules, “regular” (non-Roth) contributions go in tax-free, accumulate tax-free and then are taxed at ordinary income tax rates on distribution. Roth contributions are taxed going in, accumulate tax-free and then are not taxed on distribution.
Under the current system, there are two principal tax benefits. First, qualified plan savings avoid all investment taxes – e.g., the top-rate 20% tax on capital gains and dividends and the 3.8% tax on net investment income. Second, by saving in a qualified plan, an individual can shift income (using “regular” 401(k) contributions) from a current high-tax year to a future low-tax year; or (using Roth 401(k) contributions) to a current low-tax year from a future high-tax year.
We also note that, while investment income on plan assets is tax exempt, if (as is typical) the plan is invested in corporate stock, the plan is indirectly paying taxes at the corporate level. As one expert on the issue put it (Professor Edward Kleinbard of the USC Gould School of Law) “the corporation is … a wonderful place to collect tax on those investors who otherwise would be tax exempt without punching them in the nose with the fact that we’re now going to impose tax on them.” Thus, a reduction in corporate taxes benefits retirement savers. We discuss this issue in more detail in our article Corporate tax reform and retirement savings tax policy.
No capital gains/dividend tax rate proposal: The framework does not include any proposed change to current taxes on investment income. We will want to watch how this issue is handled – and how the “politics” of it develop – in the relevant committees.
“Steeper” brackets make income shifting more valuable: Under the framework, the current seven income tax brackets would be consolidated into three: 12%, 25% and 35%. The framework does, however, leave room for a fourth – “An additional top rate may apply to the highest-income taxpayers to ensure that the reformed tax code is at least as progressive as the existing tax code and does not shift the tax burden from high-income to lower- and middle-income taxpayers.”
Fewer brackets means the jump between brackets – and the value of getting into a lower bracket – is bigger. A 401(k) contribution that, under current rules, might move a taxpayer from a 33% to a 28% bracket might, under the framework, move a taxpayer from a 35% to a 25% bracket. The tax “saving” of 5 percentage points under current rules from income shifting would double, to 10 percentage points. We don’t know where they are pegging these new brackets – so this is just an illustration of the principle: steeper rate changes = more value to income shifting.
In this regard, Rothification would significantly limit this income shifting benefit.
Lower corporate tax rates benefit all investors but benefit retirement savers more: The framework would reduce the corporate tax rate from a top rate of 35% to 20% and allow the immediate write-off of new investments in depreciable assets. Lower corporate taxes will increase returns to all investors, including retirement plan investors. Economic theory indicates that those increased returns will quickly translate into increased asset values. Thus, some are already suggesting that the proposed reduction in the corporate tax rate would lead directly to an increase in defined benefit plan funded status.
While the reduction in the corporate tax will benefit all investors, it will, at the margin, increase the tax benefit from saving in a tax-qualified plan: the amount of tax-free investment earnings in the plan will increase, as will the tax paid by individuals saving outside of the plan.
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We will continue to follow these issues.