Despite the fact that many retirement-related provisions did not make it into the final version of the Tax Cuts and Jobs Act (TCJA), this expansive tax reform package will undoubtedly have a substantial impact on the way small-business owners plan for retirement. Tax savings may be a strong motivating factor in a small-business owner’s decision to offer a retirement plan, but many other factors come into play in making this decision. Now that the TCJA has become law, small-business owners — and their advisors — must pay close attention to the details in order to craft a tax-smart retirement plan.
Retirement Changes Under the TCJA
The TCJA eliminated a client’s ability to recharacterize a Roth IRA conversion, which will mean that clients should engage in a much more careful analysis of whether converting to a Roth makes sense. Under prior law, taxpayers who executed Roth conversions were allowed to “recharacterize” (or undo) the conversion before Oct. 15 of the following tax year.
Despite this change, the TCJA is clear that if a taxpayer makes a Roth contribution, he or she is permitted to recharacterize the transaction as a contribution to a traditional IRA before the due date for his or her income tax return for the year.
The recharacterization rules were valuable because when a client converts an IRA to a Roth, he or she pays taxes on the entire value of the amount converted at his or her ordinary income tax rates. Obviously, if the value of the Roth has declined (for example, during a market downturn), the client had the ability to recharacterize and then potentially convert the IRA assets at that lower value — generating a correspondingly lower tax liability.
Additionally, under the TCJA, the 60-day rollover requirement will no longer apply to certain qualified plan loan offset amounts. This provision applies to plan loan amounts where (1) the plan is terminated while a client’s plan loan is outstanding or (2) the client fails to make the required installment payments because the client’s employment was terminated while the loan was outstanding. This modification gives clients in these circumstances until the date their tax bill is due for the year to repay the loan balance (by contributing the outstanding amount to an IRA) in order to avoid the loan being taxed as a distribution.
Expected changes to the rules applicable to governmental retirement plans that were designed to bring these plans more in line with other qualified plans were not enacted, nor were changes designed to relax the retirement plan hardship distribution rules.
New Planning Calculus
Under the TCJA, pass-through entities (which include sole proprietorships, partnerships and S corporations) are given a 20% deduction against qualified business income. This effectively allows these business owners to reduce taxable income by 20% (the deduction phases out for certain businesses that earn above $157,500 for single filers or $315,000 for joint returns).
Many experts have predicted that this potentially lower tax rate will discourage small-business owners from offering retirement plans because the tax rate on the eventual plan distribution could be higher than the tax rate the business owner would pay on the income currently (although the top tax rate will be 37%, the 20% deduction could result in a much lower effective rate). As a result, many very small business owners could be better off tax-wise by paying taxes on the income now and saving outside of a retirement plan (or within a Roth account).
However, business owners with employees should continue to take the value of the retirement savings option into consideration as a powerful employee benefit that can help attract and retain desirable employees. Further, once the business owner is retired and begins taking distributions from the account, he or she could have dropped into a lower tax bracket so that the tax savings potential of a retirement account would not be eliminated.
While the math governing small-business retirement plans has certainly changed, advisors should not expect these plans to become obsolete — it’s important to remember that for some clients, the need for maintaining a retirement plan extends far past the basic tax savings associated with these plans.
For previous coverage of small-business retirement planning in Advisor’s Journal, see http://nationalunderwriteradvancedmarkets.com/articles/default.aspx?filename=fc103116-e.htm&search=small%20business%20retirement&type=and
For in-depth analysis of qualified retirement plans, see Advisor’s Main Library: http://nationalunderwriteradvancedmarkets.com/articles/default.aspx?filename=f111_1_111_1010.htm&search=small%20business%20retirement&type=and