With the “fiscal cliff” looming ever larger, and posturing and brinksmanship showing no signs of abating on either side of the confrontation in early December, it appears increasingly possible that one casualty of the showdown might be favorable tax treatment of 401(k) and similar qualified plans.
Currently, a number of proposals are floating around Washington, and most would either cap retirement plan contributions, tax some or a percentage of contributions to 401(k) plans, or limit tax deductions.
Under current 401(k) rules, combined employer and employee contributions are capped at $50,000 or 100 percent of an employee’s compensation per year, but a rule change—first proposed in the National Commission on Fiscal Responsibility and Reform report and recently garnering increased attention—would limit employee/employer contributions to 20 percent of an employee’s annual compensation, not to exceed $20,000, whichever is less. Commonly referred to as the 20/20 cap proposal, it will severely limit the motivation for business owners to sponsor a plan, its opponents argue.
In talking points prepared for its members, the American Benefits Council notes that the current highest levels can only be reached by owners and higher-paid employees, and that these tax incentives play a critical role in encouraging key decision-makers to sponsor and maintain plans. When business owners evaluate the responsibilities, risks and costs of voluntarily sponsoring a retirement plan, the promise of meaningful tax benefits for key employees often represents the deciding factor in choosing to move ahead, according to ABC.
Even though higher-salaried workers would be most affected by the adoption of the 20/20 cap proposal, analysis by the nonpartisan Employee Benefit Research Institute projects reductions in 401(k) balances at retirement of 4 percent to 15 percent across all income levels. The EBRI analysis suggests that the change would have an outsized impact among lower-income wage earners and the youngest retirement savers, and it reaches these conclusions even without factoring in the possibility of more employers choosing not to establish plans, or curtailing existing plans, as a result of the 20/20 proposal.
The second proposal (A Proposal to Restructure Retirement Savings Incentives in a Weak Economy with Long-Term Deficits, by William Gale of the Brookings Institution), was taken up by the U.S. Senate Finance Committee hearing on tax reform options in September 2011. Under this proposal, both employee and employer contributions to 401(k) and other qualified plans would no longer be excluded from income subject to current taxation, contributions to IRAs would no longer be tax-deductible, and any employer contributions to 401(k) plans would be treated as taxable income to the employee, just as current wages are. Instead, all qualified employer and employee contributions would be eligible for a flat-rate refundable tax credit given to the employee, and the credit would be deposited directly into the retirement savings account, as opposed to the current deduction system which simply results in a lowered current tax liability.
Since retirement plan and IRA deductions represent one of the federal government’s top three tax expenditures (employer-provided health care and mortgage interest exemptions are the other two), there is a growing belief that changes to the treatment of 401(k) plans will be on the table as part of a larger tax reform effort in 2013, regardless of what happens with the fiscal cliff. The normally low-profile American Society of Pension Professionals and Actuaries is so concerned about this possibility that it has launched a media campaign to educate U.S. employers and their employees to the fact that they may be in danger of losing some of the tax breaks their plans currently enjoy.
As Bob Holcomb, executive director of legislative and industry affairs at J.P. Morgan Retirement Plan Services, noted on a client conference call last month, the treatment of retirement plans is going to be part of overall tax reform, so employers should look at the big picture in terms of what the reforms will mean for them and their businesses. He also stressed the importance of making sure that government policymakers understand that contributions to retirement plans don’t represent “lost” funds. “The money isn’t leaving the system. It’s being invested,” he said.
Lynn Dudley, senior vice president, policy, at the American Benefits Council, warns there will likely be repercussions from any changes to the tax treatment of retirement plans. “The existing tax incentives for workplace retirement plans are essential, not just for employee participation in these plans but for continued employer sponsorship as well,” she said. “We understand that Congress faces tough choices in light of mounting debt and the fiscal cliff, but destabilizing the employer-sponsored retirement system could have serious unintended consequences for the future.”