On April 26, 2017, the Trump Administration announced a tax reform proposal. The proposal itself consists of a one-page outline of goals and individual income tax, corporate tax and simplification proposals.
In this article we begin with an outline of the elements of tax reform that affect retirement savings tax incentives and then discuss very briefly the Administration’s proposal, identifying some of the key questions that at this point remain un-answered.
Framework for analysis
The following are the critical “moving parts” of any tax reform effort that may affect retirement policy (for a more detailed discussion of these issues, see our article Retirement savings tax incentives – the current system) –
Changes in investment tax rates. Assuming constant tax rates, the tax benefit provided by the current system of retirement savings tax incentives is the non-taxation of investment earnings. Thus, the higher the tax on investment income, the more attractive tax qualified retirement savings are. And reductions in investment tax rates will reduce that attractiveness.
Increasing/decreasing the steepness of tax brackets. As we have discussed, under the current system, tax qualified retirement savings also permit taxpayers to shift income from one year to another, e.g., with respect to “regular” 401(k) contributions, from the year of contribution to the year of distribution. In doing this, taxpayers may shift income from a high tax rate year to a low tax rate year. How much of a tax benefit this generates depends on the size of the difference in tax rates, and that difference can (to some extent) correlate with the “steepness” of tax rate brackets.
This is a technical point, but for some taxpayers its value as a tax benefit significantly exceeds the value of the non-taxation of investment income. Thus, a bigger difference between the tax-rate-at-contribution and the tax-rate-at-distribution translate (for some) into a greater retirement savings tax benefit.
Changing the terms of the retirement savings tax incentives. There have been proposals to cap the exclusion for retirement savings contributions (e.g., at 28%), to cap the total amount of tax qualified retirement savings a taxpayer can accumulate (e.g., at $3.4 million), and to require that all or some portion of 401(k) contributions be made on a “Roth basis.” Each of these proposals would limit (in different ways) the value of current retirement savings tax incentives.
Reducing the corporate tax/increasing taxes on shareholders. Tax qualified retirement plans that invest in corporations indirectly pay corporate taxes. That is, earnings on their investment are taxed at the corporate level. Thus, as a general matter, a reduction in the corporate tax will increase the earnings generated by a tax qualified plan’s corporate investment. Depending on how they are implemented, proposals to offset corporate level tax reductions with shareholder level tax increases could negate that effect. (In this regard, see our article The effect of tax reform on retirement savings tax incentives – corporate tax.)
Trump Administration proposal
Given this framework, what is the Trump Administration proposing?
Investment tax rates: The Trump Administration is proposing eliminating the Affordable Care Act 3.8% tax on net investment income applicable to certain high income taxpayers. As we discussed in our article Repeal of Affordable Care Act: effect on retirement savings, this change will, at the margin (and for those taxpayers who would otherwise be subject to this tax) reduce the value of retirement savings tax incentives.
There is nothing in the proposal about changes to capital gains/dividend tax rates generally – presumably they will not change. One question: The Trump Administration is proposing eliminating the 39.6% income tax bracket, and the 20% capital gains/dividend tax rate is only applicable at that rate. Will the 20% capital gains/dividend tax rate also be eliminated or will it be imposed at the “new” highest income tax rate (35% under the Trump Administration proposal)? We need more information on this issue.
Steepness of the tax brackets/value of income shifting: Reducing the number brackets (as the proposal does) will generally increase the steepness of tax brackets and the value of income shifting. But much will depend on at what income levels the different brackets apply, and the Trump Administration has not provided that information.
Changing retirement savings tax incentives: The Trump Administration proposes to “[e]liminate targeted tax breaks that mainly benefit the wealthiest taxpayers.” This could affect retirement savings tax incentives – we will have to see details on what is in/what is out of “tax breaks for the wealthiest.”
Corporate tax changes: The proposed reduction in the corporate tax is big – from a top rate of 35% to 15%. A lot of what we’re hearing is that the Trump Administration intends to “pay for” this tax reduction by “closing loopholes” and generating economic growth (through the corporate tax cut). But the Administration seems to have an open mind on this and other issues. The one-page description states:
Throughout the month of May, the Trump Administration will hold listening sessions with stakeholders to receive their input and will continue working with the House and Senate to develop the details.
Certainly some in Congress will ask for additional revenue, and retirement savings “tax breaks” could be a target for that. Roth-only (or semi-Roth-only) proposals could also be a source of revenues to offset, e.g., the corporate tax rate-cut.
We know some things with reasonable certainty, e.g., a repeal of the ACA 3.8% tax on net investment income is likely to be part of any final Administration/Republican tax reform proposal, and that will reduce (at the margin) the attractiveness of retirement savings tax incentives. But, for the most part, we will have to wait for more details.