How Tax Reform Could Affect Retirement Plans

In her recent paper, “How Tax Reform for Retirement Plans Can Affect Risk and Compliance,” Marcia Wagner, principal and founder of the Wagner Law Group, talks about how retirement vehicles such as 401(k) accounts are not taxed until a participant takes a distribution and how these vehicles are seen by some lawmakers as a potential source of revenue.

With the federal budget deficit being what it is, says the Boston-based Wagner, there are various proposals in the pipeline that look to update the architecture of retirement vehicles and thus provide more revenue that could be used to alleviate the deficit. The ones covered in Wagner’s paper include:

• Updating the U.S. tax code rules to reduce tax expenditures and raise revenue;
• The 2014 Tax Reform Act (TRA) from Dave Camp, chairman of the U.S. House of Representatives Ways and Means Committee;
• An Obama Administration proposal to regulate contribution limits by seeking to cap the aggregate accumulation in all tax-favored retirement plans;
• The 20/20 Proposal from the National Commission on Fiscal Responsibility and Reform; and
• A proposal from the Brookings Institution that would shift the benefits of retirement plans more towards non-highly compensated employees.

When asked about how the proposed 2014 Tax Reform Act (TRA) and how freezing the contribution limits for 10 years would generate revenues for the federal government, Wagner tells PLANSPONSOR, “Anything that has an after-tax status is revenue. It may well be that the time of annual contribution limits, and pre-tax limits in particular, is coming to an end.

“If this does turn out to be the case, there will definitely be a disincentive, especially in the non-highly compensated realm, to using after-tax retirement vehicles. On the one hand, people are not saving enough for retirement as it is. On the other hand, the country needs the revenue from the taxes the TRA would bring and may not be able to continue using the pre-tax model for retirement vehicles in the coming years.”

When asked if the need to keep track of both pre-tax and after-tax contributions for the TRA would increase the administrative burdens on retirement plans, Wagner says, “Yes, definitely. Many administrative systems will clearly have problems handing both. The question then becomes who is legally responsible for taking on this burden. It really opens up a whole hornet’s nest of trouble. Plan sponsors really need to be aware of the system capabilities, and limitations, of their recordkeepers. Plan sponsors will still need to follow due diligence steps when it comes to keeping records about pre-tax and after-tax contributions.”

In terms of the proposal by the Obama Administration to cap the aggregate accumulation in all tax-favored retirement plans, Wagner says, “Recordkeeping for such aggregate accumulations is easier said than done.” Again, she says, plan sponsors need to know their recordkeeper’s capabilities. Wagner adds that the Obama Administration needs to flesh out the standards more, especially to clarify recordkeeping responsibilities.

If limits on deductions for 401(k) contributions are instituted to generate more tax income, thus impacting high-income participants, how will plan sponsor deal with an increased demand for Roth features by these high-income participants? Wagner says, “I suspect you will see more recordkeepers offering more bundled services to handle the demand. Something else that might happen is that plan sponsors may look to do more outsourcing to an ERISA 3(16) fiduciary.”

Wagner says it is also possible that the high-income/highly compensated employees will begin pushing plan sponsors to offer more Roth plan features, such as Roth 401(k) accounts or Roth IRAs (individual retirement accounts).

When it comes to the 20/20 Proposal from the National Commission on Fiscal Responsibility and Reform—which recommends limiting the maximum excludable contribution to a defined contribution plan to the lesser of $20,000 or 20% of income—Wagner agrees that reduced employee contribution limits will discourage plan participation, reduce overall plan assets, and ultimately means there will be less money to tax. “From the federal government’s standpoint, you want to encourage employees to save for retirement, but you also need to create revenue, so there has to be a balance,” says Wagner.

In terms of which of the proposed tax reforms can achieve this balance—raising tax revenue while still benefitting employees and employers—Wagner believes the approach of limiting cost-of-living adjustments (COLA) has the best chance of success. This approach applies to the updating of the U.S. tax code in the area of plan contribution limits and the proposal in the Tax Reform Act to freeze defined contribution plan limits from 2014 to 2024, then allow these limits to increase in synch with COLAs.

A copy of Wagner’s paper can be found here. To find out more about reproducing the paper, which originally appeared in the journal Practical Compliance and Risk Management for the Securities Industry, please call 866-220-0297.