One element of tax reform for which there seems to be some bipartisan support is “doing something about the corporate tax.” Thus, even if after the November election we continue with a divided government, action on corporate tax reform is possible. For many corporate retirement plan sponsors, interest in reforming the current system of corporate taxation vastly outweighs interest in changes to retirement savings tax policy.
Changes in corporate tax policy are, however, likely to secondarily affect the retirement savings “tax deal” – the attractiveness of saving in a tax qualified retirement plan – and we discuss those secondary effects in this article. While not all businesses are incorporated and taxed as a corporation, the general policy discussion might inform us of changes to the taxation of other forms of a business, like a partnership.
Tax qualified retirement plans and the corporate tax
We are not experts on the corporate tax, and we are not going to go into a lot of technical detail on the different issues presented by the current corporate tax system and proposed changes to it. But, to review the basics: very generally (and oversimplifying), corporations pay taxes at the corporate level; dividends are not deductible; and shareholders pay taxes on (qualifying) dividends at capital gains rates. Thus there are two taxes on corporate earnings: (1) one at the corporate level; and (2) one at the shareholder level. This is sometimes called the double taxation of corporate earnings.
Tax qualified retirement plans/trusts are tax-exempt entities. As such, they do not pay the shareholder level tax. They do, however, indirectly pay the corporate level tax; that is, the earnings from their investment in a corporation are subject to tax, at the corporate level. In his remarks at a recent conference on the issue, Professor Edward Kleinbard (USC Gould School of Law) described this feature of the current system vividly: “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.” (US corporate tax reform in 2017: Exploring the options, American Enterprise Institute, June 7, 2016.) The highest current corporate level tax rate is 35%; that rate is one of the highest in the world, and there is broad and bipartisan sentiment that finding a way to lower it would be a good thing.
Because investments in tax qualified retirement plans are not subject to the shareholder level tax on dividends (or, for that matter, capital gains), they do enjoy a tax advantage vis a vis non-plan investments. The following chart describes the shareholder level tax (for joint filers) on dividends and capital gains.
|Taxable Income||Capital Gains/Dividends|
|$0 – $18,550||0%|
|$18,551 – $75,300||0%|
|$75,301 – $151,900||15%|
|$151,901 – $231,450||15%|
|$231,451 – $413,350||15%|
|$413,351 – $466,950||15%|
In addition, the Affordable Care Act of 2010 added a 3.8% Medicare net investment income tax applicable to joint filers with adjusted gross income over $250,000.
Assuming constant tax rates (that is, the participant is paying the same income tax rate at the time of contribution and distribution), the non-payment of these taxes on investment income constitutes the entirety of the qualified plan retirement savings tax advantage.
Changes to the current system
A number of the proposals that have been made to reform the current corporate tax system would affect the level of corporate and shareholder taxes, including:
Reducing corporate level taxes and broadening the corporate level tax base (by, e.g., reducing or eliminating certain corporate level deductions).
Reducing corporate level taxes and increasing shareholder level taxes.
Taxing all corporate earnings at the shareholder level only.
In discussing these proposals, we should note that bipartisan support for them depends on their “revenue neutrality” (that is, that any reduction in taxes/revenues in one part of the corporate tax system will be offset by an increase in taxes/revenues in some other part of it) and their “fairness” (e.g., that any change in “who pays” corporate taxes won’t increase the tax burden on wages).
Significance for plan sponsors
For many (most?) plan sponsors, the effect on corporate finances of changes in the corporate tax system is much more important than any secondary effect it may have on retirement savings. But, if there is corporate tax reform, there is every possibility that it will affect the retirement savings “tax deal” – making tax-qualified retirement savings either more or less attractive. And sponsor officials responsible for company retirement benefits policy will, as the corporate tax reform debate proceeds, want to consider that (secondary) effect – for instance, how changes in the tax on dividends may affect the “tax appeal” of the company’s 401(k) plan – and its implications for benefits policy. In that regard, here are two rules of thumb:
Increases/decreases in taxes at the corporate level will reduce/increase returns to all savers, regardless of whether they are saving inside a plan or outside a plan.
Increases/decreases in taxes on individual savers (e.g., an increase/decrease in the tax on dividends or capital gains) will make saving inside a plan more/less attractive.
Thus, one proposal, advocated by Rosanne Altshuler (professor of economics at Rutgers University) and Harry Grubert (senior research economist in the Office of Tax Analysis at the US Department of the Treasury), would reduce the corporate level tax to 15% and increase the shareholder level tax to ordinary income tax rates (where the top rate is 39.6% plus the 3.8% Medicare net investment income tax). Under such a proposal (and similar reduce-the-corporate-rate/increase-the-shareholder-rate proposals), the corporate level tax that qualified plans do currently pay (indirectly) would go down, while the shareholder level tax that they do not pay would go up. That result would generally make qualified plan retirement savings (significantly) more attractive.
On the other hand, a proposal (“corporate integration”), currently under consideration by the Senate Finance Committee, to eliminate the corporate level tax on earnings (to the extent of dividends paid) and replace it with a 35% nonrefundable shareholder level dividend tax, paid by all shareholders (and, apparently, regardless of tax exempt status), would eliminate the qualified plan retirement savings tax advantage (at least with respect to dividends). (We will consider this corporate integration proposal in more detail in a subsequent article.)
Either of these changes would significantly change (one positively and one negatively) the tax value of saving in a qualified retirement plan.
We will continue to follow this issue.