Retirement plan industry expert speakers have been talking about how potential tax reform may affect employer sponsored retirement plans, such as 401(k) plans, for the last many years. However, there are now a number of converging factors that increase the likelihood of major tax reform actually happening. Given this, it makes sense to take a brief look at what’s driving the discussions on Capitol Hill and highlight several of the key proposals.
So why is tax reform now more likely in the 113th US Congress than in the past? First, Congress must yet again address the debt ceiling sometime between now and September or October 2013. Secondly, House Republicans, led by Congressman Dave Camp (R-MI) Chairman of the House Ways and Means Committee, are trying to tie tax reform to an increase in the debt ceiling. And third, Senator Max Baucus (D-MT) Chairman of the Senate Finance Committee is apparently not running for re-election which provides him greater freedom in approaching proposed legislation and tax reform. And while President Obama has expressed a desire to have a no-strings-attached debt limit increase, Baucus has publicly stated he’s enough of a realist to know that the different members of the House and Senate have varying ideas on the subject and negotiations are going to play a key role.
With a climate for tax reform strengthening, it’s wise to gain an understanding of where reform might take 401(k) plans. Three notable possible courses of action deserve our attention:
- President Obama’s FY2014 Budget released in April of this year proposes a significant change to the tax treatment of 401(k) contributions made by higher income earners. In this proposal, families with an adjusted gross income of $250k or more would have to treat their 401(k) contributions as taxable income instead of pre-tax contributions. Furthermore, their 401(k) contribution would be subject to a 7% - 11% tax surcharge. Plus, their distributions down the road at retirement would also be taxed at the prevailing rate. This concept of “double taxation” is troublesome for many and has the attention of the American Society of Pension Professional & Actuaries (ASPPA) which opposes this proposal. In ASPPA’s view, such a proposal could potentially lead to reduced support of employer sponsored 401(k) plans since it is likely those affected by this proposed rule may be business owners and decisions makers who would lose a primary personal benefit in sponsoring their 401(k) plan
- President Obama’s budget also proposed a $3 million lifetime aggregate cap on 401(k) and IRA contributions. In this proposal, once an individual accumulates a total of $3 million across his/her combined 401(k) and IRA accounts, they would no longer be able to make any further contributions to these retirement plan vehicles. Again, ASPPA warns that this proposal could reduce the attractiveness of sponsoring a 401(k) plan by successful business owners who have effectively utilized their plan to accumulate significant retirement security.
- As with the Fiscal Cliff deal (see: New Roth Opportunity for 401(k) Plans per Fiscal Cliff Deal) passed in January, there is a continued appetite on Capitol Hill to proactively push for more Roth, taxable contributions into 401(k) plans vs. the customary pre-tax contribution. As Congress evaluates tax reform, it typically does so within the lens of a 10-year view. With that relatively short time horizon as the yard stick, the IRS and Treasury see Roth contributions as tax revenue positive and they provide a positive impact on the budget deficit. While there is much commentary of the longer term tax revenue losses represented by Roth contributions since the government forgoes taxing investment gains accumulated over many years when they’re distributed at retirement, taxing Roth contributions today provides a near term budget win. As a result, there is potential for the annual limit on pre-tax 401(k) contributions to be significantly reduced within the range of $7,000 - $10,000 (vs. $17,500 in 2013) and augment this with expanded Roth contributions.
Clearly, much is unknown at this time about where tax reform will take us. The three proposals illustrated above are only but of few of the many different tax reform approaches that will be debated in the coming months. But the point is clear, as the debt ceiling and tax reform debate heats up in Washington, retirement plans in general, and 401(k) plans in particular, are likely to be part of the negotiations to address the budget deficit.
We will continue to monitor this evolving story and keep you informed of any actual changes to the rules affecting your retirement plan. In the meantime, we invite you to express your voice through ASPPA at www.savemy401k.com.