As Republicans on Capitol Hill begin the heavy lifting of reforming the country’s corporate and individual tax codes, lawmakers are forming proposals that would dramatically impact the tax-preferential treatment of 401(k) plans.
One idea being floated would treat all 401(k) deferrals as after-tax contributions, as Roth 401(k) deferrals are now treated.
That would create a seismic change to the country’s employer-based retirement system, and poses potential unintended consequences that industry insiders fear will disincentivize employers from offering defined contribution retirement savings plans.
“This idea would be devastating for our retirement system,” said Will Hansen, senior vice president for retirement policy at the ERIC Industry Committee, which advocates on behalf of large sponsors of retirement and health plans.
In a recent interview on Fox Business, President Donald Trump walked back a soft deadline for finalizing tax reform legislation by August, a timeline publicly suggested last month by Treasury Secretary Stephen Mnuchin.
Nonetheless, Hansen said ERIC is treating the proposal to shift to an all-Roth system as more than beltway speculation. The trade organization is not waiting for a formalized proposal to push back against the idea. “It’s never too early to draw your line in the sand on what you believe is the best policy for our retirement system,” he said.
On the campaign trail, President Trump pledged to reduce the number of individual federal income tax brackets from seven, which now range from 10% to 39.6%, to three brackets—10, 20 and 25%.
He also proposed cutting the corporate tax rate from 35% to 15%. The House Republican blueprint for tax reform, also released last year, set the goal of slashing the corporate rate to 20%.
Estimates of Trump’s proposal range around $12 trillion over a 10-year period. In order to pass tax reform through budget reconciliation, those costs will have to be offset in part by eliminating current deductions in the tax code.
“Republicans are going to need revenue to pay for those cuts,” said Hansen, echoing a reality other industry advocates have been warning against since Trump’s election. “The clues are out there. If tax reform moves forward there will be some treatment to how retirement plans are taxed.”
The latest figures from the Joint Committee on Taxation show the tax-exempted status of defined contribution plans will result in $583.6 billion in forgone revenue between 2016 and 2020. Exemptions on traditional IRA contributions will cost $85.8 billion.
That Republicans passed on capping the exemption for employer-provided health benefits in the American Health Care Act makes new taxes on 401(k) deferrals all the more likely, says Hansen.
Republican leaders have given other indications that the tax incentives for retirement plans are a likely source for revenue offsets.
The Republican blueprint for tax reform eliminates all itemized deductions, except deductions for mortgage interest and charitable donations.
The blueprint does not give specific changes to the tax treatment of retirement plans, but does pledge to “continue tax incentives for retirement savings,” and says the House Ways and Means Committee will develop “options for an effective and efficient overall approach to retirement savings.”
“The language suggests they are going to protect deferral limits in accounts, but it doesn’t say they won’t change how deferrals are taxed,” noted Hansen.
Congressional Republicans have also proposed the creation of Universal Savings Accounts, which would be modeled on retirement savings accounts as a way to create tax incentives to save. But those accounts would allow individuals to withdraw contributions, and investment earnings, at any time, for any reason, and without a penalty.
In 2014, Rep. Dave Camp, R-Mich., then chairman of the Ways and Means Committee, introduced tax reform legislation that would have limited pretax contributions to 401(k)s to half the annual contribution limit. The remainder of an individual’s contributions could be made on an after-tax basis.
But even with that early indication, Hansen says industry, and Congress, are flying blindly as to how Camp’s proposal, and the more aggressive idea of shifting all contributions to an after-tax basis, would impact savings rates.
“I don’t think anyone has closely examined what a massive swing to an all-Roth system would mean, and without that we should be very concerned if Congress is willing to do as much just to raise money,” said Hansen.
So far, it’s unclear if Congress is considering taxing employers’ contributions. Even if that were spared, employers would still see increased payroll tax exposure.
That reality would be enough for employers to reconsider offering 401(k) plans, particularly in the small plan market.
“In the small plan market, business owners are typically doing all the work it takes to run a 401(k) plan themselves,” said Adam Pozek, co-founder of DWC ERISA Consultants, a St. Paul, Minnesota-based third-party administrator. “Offering a plan is primarily a business-owner tax benefit.”
An added complexity to the prospect of shifting all retirement plan contributions to an after-tax basis is the role of Health Savings Accounts, a cornerstone of Republicans’ health care reform hopes.
Increased pretax limits on HSAs, coupled with new Universal Savings Accounts, could further sour employers on 401(k) plans, says Pozek.
“From a policy standpoint, it makes more sense to encourage employers to offer 401(k) plans,” said Pozek. “We know that people are 15 times more likely to save for retirement when they have access to a plan through work. If you take away employers’ incentive to offer a plan, you’re taking away access to savings options.”