Ironically, tax reform too seems to be a once-in-a-generational thing. It’s been 30 years since the Tax Reform of 1986 cut tax rates1 – and cut into retirement plan saving and formation with the creation of the 402(g) limit (and its tepid COLA pace), not to mention the cost and timing issues associated with multiple iterations of the nondiscrimination testing that often produced problematic refunds for the highly compensated group. There’s little question that those changes (and others) did what they were designed to do – generate additional tax revenue by limiting the deferral of taxes. But what did those constraints do for retirement security?
Much of that damage wasn’t repaired until – well, 2001 with the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) – which, somewhat ironically, introduced the concept of the Roth 401(k).
While tax reform has wrought its damage on retirement savings before, this time around a new way to raise revenue has emerged – “Rothification,” loosely defined as the limiting or elimination of the current pre-tax contribution limits.
We don’t really know what workers would do confronted with that kind of change (the surveys that are available – though not completely on point suggest that the response might be modest) – though we do know that if current participants continued to save at the same rate, retirement readiness would likely improve. There are also signs that it would be seen as a big enough change that some, perhaps many, plan sponsors would want to rethink, if not reconsider, their current automatic enrollment assumptions.
We may not know with certainty those outcomes, but there are lots of reasons to be nervous, if not downright fearful of change to retirement plans, particularly one that seems likely to give plan sponsors – and plan participants – a reason to rethink their current savings rates. Granted, surveys show that most plans already offer a Roth option, and more recent surveys indicate that most plan sponsors would continue to offer a plan even if the current pre-tax option for 401(k)s was reduced and/or eliminated (and how sad would it be if a plan sponsor decided to walk away from offering a plan just because the pre-tax savings option was clipped).
We also know that more than half of current 401(k) contributors would be affected by a $2,400 pre-tax contribution limit, based on data from the non-partisan Employee Benefit Research Institute (EBRI), using their Retirement Security Projection Model® (based on information from millions of administrative records from 401(k) recordkeepers), and that the impact reaches down to some very moderate income levels.
That said, we don’t yet know – and this is significant – if the tax reform proposals that emerge this month will include some version of Rothification, nor at what level the Rothification restriction might be imposed (as it turns out, Rothification was NOT included in this first round!).
Consider the recent “unintended” consequence of a proposed tax break for pass-through entities (i.e., partnerships, S corps, and small business limited liability corporations). More than 320,000 of these entities sponsor a retirement plan (with the average size being 75 employees) – unfortunately, many of these businesses may reconsider adopting or maintaining a qualified retirement plan because of significant financial disincentives woven into the fabric of the tax reform proposal, which would establish a 25% maximum pass-through rate on that business income, versus the 35% top rate on ordinary income (as well as the favorable tax rate on capital gains income at 20%) that would be assessed when the money is withdrawn at retirement. In other words, the small business owner’s plan contributions and accumulated earnings will be taxed at 35% instead of the 25% pass-through rate and the 20% capital gains rate on accumulated earnings.
There are some things about tax reform proposals that we do know. One, that lawmakers – and sometimes regulators – often seem to operate on the assumption that employers will, and indeed must, offer a workplace retirement plan no matter what changes or cost burdens are imposed on plan administration. With an eye toward narrowing the benefit gap between higher-paid and non-highly compensated workers, limits are imposed that often outweigh the modest financial incentives offered to businesses, particularly small businesses, to sponsor these programs. This, despite the striking coverage gap among those who work for these small businesses, and the potentially burdensome administrative requirements and additional costs that the owner must absorb, alongside a pervasive sense that their workers aren’t really interested in the benefit (or, perhaps more accurately, would prefer cold, hard cash).
The debates about modifying retirement plan tax preferences – or the notion that these preferences are “upside down,” and thus may be dispensed with – are bandied about as though those changes would have no impact at all on the calculus of those making the decisions to offer and support these programs with matching contributions. In other words, while some attempt is made to quantify the response of workers to changes in their incentives, most studies simply assume that employers will “suck it up.”
Well, this week the GOP is slated to unveil its proposal for tax reform in the House of Representatives, and shortly thereafter we should see a separate GOP proposal emerge in the Senate. Those will have to be reconciled, and these days that’s no slam dunk.
It remains to be see what tax reform – with all its laudable objectives – might mean for retirement plans this time around. But here’s hoping that, if tax reform turns out to be “Pennywise,” it won’t be “pound” foolish.
- Nevin E. Adams, JD
- And the time before that was 1954… with the creation of the Internal Revenue Code.