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Tax provisions of the budget reconciliation package – effect on retirement plans

On September 15, 2021, the House Ways and Means Committee passed Subtitle I (generally, the income tax provisions) of the “Build Back Better Act” – Congressional Democrats’ FY 2022 budget reconciliation legislation. Subtitle I includes revisions to corporate and individual income and capital gains taxes and certain changes to the Internal Revenue Code with respect to Roth conversions and individuals with large IRA and defined contribution plan accounts.

In this article we briefly review how these changes may affect corporate defined benefit plan funding policy, retirement savings tax incentives, and employer sponsored, tax qualified retirement plans.

Except where noted, all changes are proposed to be effective in 2022.

Increase in corporate tax

For corporations with income in excess of $10 million, the corporate tax rate would be increased (generally) from (current) 21% to (proposed) 26.5%.

This would create an incentive for corporations to defer contributions for 2021 to 2022: The deadline, for calendar year plans, for contributions for the 2020 year (September 15, 2021) has already passed. The deadline for contributions for 2021 is (generally) September 15, 2022. Sponsors, e.g., considering making contributions for 2021 to reduce Pension Benefit Guaranty Corporation variable-rate premiums (VRPs), may make those contributions as late as that September 15, 2022, deadline. If those contributions are made in 2022, then (if the new corporate tax rate is adopted) they generally may be deducted in 2022 at the higher rate.

Increase in highest individual tax rate

The marginal individual income tax rate for high income individuals (e.g., joint filers with income over $450,000) would generally be increased to 39.6%.

Increase in investment tax rates

The capital gains rate for these “high earners” (those paying the 39.6% income tax rate) would be increased from 20% to 25%. The new rate applies to taxable years ending after September 13, 2021 (the date of introduction), with a special transition rule for years (e.g., calendar 2021) that include September 13, 2021.

Effect on retirement savings tax incentives

Bottom line: The increase in the capital gains tax will make saving inside a plan more valuable (relative to saving outside a plan) – that is, the tax incentive for retirement savings will increase.

Here’s the more complicated version, with numbers: We estimated values for inside-the-plan and outside-the-plan savings under the current system and the Build Back Better proposal, using (as a simplified example) a $1,000 pre-tax 401(k) plan contribution left in the plan for 10 years. For the outside-the-plan saver, we assume that each year’s earnings are taxed at capital gains rates each year.

Inside-the-plan vs. outside-the-plan savings — current vs. proposed

Basic AssumptionsCurrentProposedImpact of Proposal
Contribution$1,000$1,000
Earnings rate5.0%5.0%
Years in plan1010
IT rate at contribution37.0%39.6%
CG20.0%25.0%
IT rate at distribution37.0%39.6%
Medicare NII rate3.8%3.8%
Value at ten years (after taxes) in-plan$1,026$984($42)
Value at ten years (after taxes) out-of-plan$916$857($59)
Value of in-plan savings$110$127

On these assumptions, under current rules, an individual saving inside a plan has, after 10 years, $111 more than she would have had had she saved outside a plan. Under the proposal, that same individual would have $126 more than if she saved outside a plan. Note, also that, while the relative value of in-plan saving goes up, the total value of both in-plan and out-of-plan saving goes down – because of the higher income tax rate (proposed 39.6%), e.g., on distribution from the plan.

Changes to business income tax

We also note that the bill would extend the Medicare net investment income tax to cover “net investment income derived in the ordinary course of a trade or business for taxpayers with greater than $400,000 in taxable income (single filer) or $500,000 (joint filer), as well as for trusts and estates.” And the deduction of Qualified Business Income would be capped for high earners.

Depending on the firm, these changes may also create additional incentives for in-plan savings.

Limits on accounts/mandatory distributions from IRAs and defined contribution plans

As noted, Subpart B of the proposal includes several provisions designed to limit the ability of taxpayers to accumulate “large retirement account balances” and Roth conversions. Summarizing:

  • Contribution limit: Contributions to IRAs would generally be prohibited where the total IRA and defined contribution plan accounts of high earners exceeds $10 million.
  • Required distributions from large account balances: Also, with respect to these accounts, in the year following the year in which the $10 million limit is exceeded, a minimum distribution of 50% of the excess would be required. Where the total in IRA and DC accounts exceeds $20 million, the lesser of that excess, or the total in Roth IRAs and Roth DC accounts, would have to be distributed from Roth IRAs and Roth DC accounts.
  • Elimination of conversions for high earners and of nondeductible contributions: The proposal would prohibit IRA and qualified plan Roth conversions for high earners beginning in 2032. And it would prohibit Roth conversions of nontaxable amounts (that is, nondeductible contributions) beginning in 2022.
  • DC reporting of large balances: DC plan administrators would be required to annually report to IRS, and to the participant, balances over $2.5 million.

Outlook

The fate of this legislation depends, most of all, on the fate of the Build Back Better Act more generally. Critically, that legislation, to pass with only a 50 vote + the Vice President as President of the Senate “majority” in the Senate, needs the support of the entire Senate Democratic caucus.

As has been widely reported, there is currently lack of agreement in the Democratic caucus on the bill’s treatment of prescription drug prices. And there are likely to be other issues which will have to be ironed out amongst Democrats before the legislation can be passed.

We will continue to follow these issues.

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