Retirement savings tax incentives – the current system
After the failure of the House to vote on repeal and replacement of the Affordable Care Act, it appears that Congress will now turn to consideration of tax reform. In any case, both Treasury Secretary Steven Mnuchin and House Speaker Paul Ryan (R-WI) have stated that they intend to move on tax reform before August of this year. As we have discussed in prior articles, reform of the Tax Code is likely to have a significant effect on retirement savings policy.
We will be covering the tax reform process – as it affects retirement savings policy – in detail, as it develops. But at the beginning of this process, we want to frame the issues that Congress will be considering. In this article we will review how the current system of taxation affects taxpayer and employer retirement savings decisions, and then we’ll briefly identify some of the key issues that we will be covering in the future.
The current system
Below are the income and capital gains/dividend tax rates applicable under the current system to joint filers in 2017 (throughout this article, when we discuss tax rates, we will only give the rates for joint filers).
|Taxable Income||Marginal Tax Rate||Capital Gains/Dividends|
|$0 – $18,650||10%||0%|
|$18,651 – $75,900||15%||0%|
|$75,901 – $153,100||25%||15%|
|$153,101 – $233,350||28%||15%|
|$233,351 – $416,700||33%||15%|
|$416,701 – $470,700||35%||15%|
In addition there is a 3.8% Medicare net investment income tax, applicable to joint filers with adjusted gross income over $250,000.
Retirement savings tax benefits
Generalizing: under the current system, (non-Roth) contributions to a tax qualified retirement plan are excluded from taxable income; earnings accumulate tax free; and contributions plus earnings are taxed at ordinary income tax rates when distributed.
This system of taxation provides two direct tax benefits: First, assuming the participant’s tax rate is the same at the time of contribution and distribution, the value of the retirement savings tax benefit is the value of the non-taxation of trust earnings. This point must be emphasized: the value of the 401(k) tax benefit is not the value of the tax exclusion, it’s the value of the exemption from taxation of trust earnings.
Second, where the participant’s tax rate is higher at the time of (a non-Roth) contribution than it is at the time of distribution, the value of the retirement savings tax benefit is also the difference between those two tax rates. This works both ways. If you are paying higher taxes in the year of contribution than in the year of distribution, then a non-Roth contribution shifts income from a higher tax rate year to a lower tax rate year. If you are paying lower taxes in the year of contribution than in the year of distribution, then a Roth contribution does the same thing.
Effect of possible reduction in investment taxes: Given this treatment – the non-taxation of trust earnings as the primary retirement savings tax benefit of the current system – reductions in the taxation of investment currently being considered by the Trump Administration and Congress (e.g., a reduction in capital gains and dividends tax rates or the elimination of the Medicare Net Investment Income tax) would have the effect of (marginally) reducing those retirement savings tax benefits, because the taxes on non-plan saving would have been reduced.
Roth vs. non-Roth treatment
We are hearing that House Republicans are seriously considering mandating that all or some portion of 401(k) contributions be contributed on a “Roth basis.” Our next article will cover this issue in detail. In this article, we simply want to spell out the difference in tax treatment of Roth and non-Roth contributions.
Generalizing: Roth contributions are taxed on the way in but not on the way out; non-Roth contributions (“regular” 401(k) contributions) are taxed on the way out but not on the way in. Assuming the participant’s tax rate is the same at the time of contribution and distribution, the participant receives the identical tax benefit: the non-taxation of trust earnings.
Roth contributions present a number of issues: they produce more tax revenues up-front (probably the main reason Republicans are considering some sort of Roth mandate); they favor those (e.g., younger taxpayers/employees) whose current income/income tax rate is lower than their (anticipated) future income tax rate; there is some evidence that some participants are reluctant to make Roth contributions; and – the way the math works – taxpayers/participants can actually finance a greater benefit with Roth contributions. We will discuss all of these issues in our next article.
The corporate tax and retirement savings tax incentives
In addition to income and investment tax reform, corporate tax reform (or changes in investment taxes as part of corporate tax reform) may also affect retirement savings tax incentives.
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.
However, many have proposed that, to insure revenue neutrality, reductions in the corporate tax should be accompanied by, e.g., increases in taxes on shareholders. Which raises the question – should that shareholder tax increase apply to tax exempt shareholders (such as tax-qualified retirement plans)? For instance, one proposal that has been floated is “corporate integration,” under which (generally) corporations would get a deduction for dividends paid, and those dividends would be subject to a nonrefundable withholding tax (e.g., of 35%). To be clear, because this withholding tax is nonrefundable, tax exempt shareholders (including tax qualified retirement plans) would pay it. In Professor Kleinbard’s words, this withholding tax would “punch tax exempt entities in the nose.”
There are other corporate tax reform proposals: some that would increase retirement savings tax benefits and some that would decrease them. When we cover corporate tax reform, we will be focusing on that issue – its affect on retirement savings tax incentives.
Cutting tax benefits for the “high paid”
There have been several proposals to cut back retirement savings tax benefits for the “high paid.” While these have generally been associated with Democrats, they have gotten some Republican support. And, in a situation in which cutting the corporate tax and marginal income and investment taxes are policy priorities, generating revenues to offset those cuts via reduced retirement savings tax incentives for high paid taxpayers is an attractive option.
We would identify two general policy initiatives aimed at reducing retirement savings tax benefits for the high paid:
Capping the exclusion. The Obama Administration proposed capping the exclusion at 28% – thus, for instance, a taxpayer in the 39.6% bracket would pay an 11.6% tax on a regular 401(k) contribution. Given an intent to reduce marginal income tax rates, and possibly mandate Roth treatment, these numbers and the timing of taxation would probably change, but the point is the same: impose some sort of additional income tax on high paid/high marginal tax rate retirement savers.
Capping the total benefit. The Obama Administration also proposed capping the total benefit a taxpayer could accumulate in IRAs and defined contribution and defined benefit plans at (approximately) $3 million. How the defined benefit element of this would be managed was never clear. A more workable proposal that has been floated would be to cap IRA and DC contributions at $2 million.
Retirement savings tax policy as a revenue target
Finally, it’s possible (even likely) that changes to the current system of retirement savings tax incentives will be made simply to raise revenues. Arguably, a Roth-only proposal would come under this heading. Congress may also consider:
Increasing PBGC premiums – even though the last increase in premiums drew significant criticism and the Obama Administration (in its 2017 budget) said: “The Administration believes additional increases in single-employer premiums are unwise at this time and would unnecessarily create further disincentives to maintaining defined benefit pension plans.”
Further extending DB funding relief.
A handful of minor retirement policy changes that have been under consideration for years, including elimination of “stretch” payouts from IRAs and DB and DC plans; elimination of the ESOP dividend deduction; and enhancing the ability to do in-plan Roth conversions.