While many small-business clients would welcome the 25% maximum tax rate for pass-through income proposed by the GOP tax reform framework, the proposed tax rate structure has the potential to hinder these clients’ retirement planning options.
Although the issue itself could be resolved in the actual legislation generated by the framework, there is a realistic possibility that the proposal could very easily discourage small-business owners from providing the currently available retirement savings options to their employees. However, many have pointed to the significant non-tax reasons that can motivate small-business owners to develop retirement planning options for both themselves and employees—and only time will tell which side Washington will find most persuasive.
Potential Impact of the Framework Tax Structure
Under the GOP tax reform framework released last week, pass-through entities (which include sole proprietorships, partnerships and S corporations) would be subject to a maximum 25% tax on pass-through income. This income is reported on the individual business owners’ income tax returns, rather than at the entity level.
Individual business owners, however, would see their personal income taxed at a top marginal income tax rate of 35% (though the framework leaves open the possibility that an even higher tax rate would be established for the wealthiest taxpayers).
Because income drawn from a traditional retirement account is contributed on a pre-tax basis and is taxed at the account owner’s ordinary income tax rate when it is withdrawn, that income could potentially be taxed at a rate that is 10% higher than the rate that would apply if the income were taxed currently as pass-through income. Further, capital gains tax rates are not included in the framework, so the maximum capital gains rate would presumably remain at 20%—meaning that earnings on pass-through income that is invested in taxable investments would also be taxed at a much lower rate.
For small-business owners in the highest income tax bracket, this could create a powerful tax incentive to stop offering retirement savings options (which can also subject these business owners to fiduciary liability and administrative costs) and simply plan for their own retirements by using taxable investments. This tax dichotomy has the potential to create a wide-reaching disincentive to retirement savings, especially because an estimated 90% of businesses are organized using a pass-through structure.
Motivations to Maintain Retirement Planning Status Quo