Experts caution tax reform could force employers to stop offering 401(k)s
Many in the retirement industry believe that if Congress implements rumored changes to defined contribution plans as part of its overall tax reform initiative, plan sponsors won’t have enough incentive to continue offering retirement plans to their employees.
One little-talked-about proposal of tax reform — set to be released by Republicans Thursday — that could have significant consequences on retirement readiness is the proposal that deals with pass-through entities, like partnerships, S corps and small business limited liability corporations. The proposal “basically presents an S Corp with the choice between paying 25% tax on income now or setting it aside for retirement and paying 35% on that money when it is withdrawn in retirement,” says Nevin Adams, speaking on behalf of the American Retirement Association.
Such a change would be wide-reaching, says Craig Hoffman, general counsel for the American Retirement Association, because more than 90% of businesses are organized as pass-through entities and more than 320,000 of them sponsor retirement plans.
“Unfortunately, many of these businesses may reconsider adopting or maintaining a qualified retirement plan because of significant financial disincentives woven into the fabric of the tax reform proposal,” Hoffman wrote in a September article on NAPA.net.
That’s because a business would pay much less in taxes if the amounts are passed through rather than saved in a qualified retirement plan. It is much less expensive to pay the 20% capital gains tax on investment earnings than to be taxed 35% on the business owner’s retirement plan contributions and earnings at retirement, Hoffman says.
“Unless this mismatch of tax rates on current pass-through income and deferred retirement savings is addressed in tax reform, the owners of pass-through entities will be financially penalized for saving in a retirement plan — and that doesn’t consider the additional administrative costs and ERISA liability risks that business owners assume in sponsoring a workplace retirement plan,” Hoffman says.
Adams says the American Retirement Association has been concerned that tax reform would be paid for — at least in part — by taking money from retirement savings’ preferences.
“That was certainly the case in 1986, where the creation of things like the 402(g) limit placed a hard cap ($7,000) on what many small business owners were putting aside for their own retirement — and in many cases, if you take away the personal incentive for a small business owner to set aside money for retirement, they may well decide not to sponsor these programs for their workers,” Adams says.
He adds that “even relatively low-income workers are 15 times more likely to save for retirement if they have a plan at work than if they have to save on their own. Unfortunately, many of those who create tax policy don’t seem to appreciate the connection between the incentives for a business owner to create and save in a workplace plan. That owner likely has other ways to save, but the workers they employ may not, or may not know where/how to start.”
Rumors are floating around D.C. that Congress plans to place a $2,400 cap on pre-tax retirement plan contributions.
Edward Chairvolotti, CEO of Chairvolotti Financial in Winter Park, Fla., says that his company works with more than 150 401(k) plans across the country. From the employer’s perspective, he says, any cap on what people can contribute to their 401(k) plan would be a disincentive for business owners to offer a plan.
“In some small plans, even like our own, I want to use it to retire. My cost is a break-even for my tax benefit — the effective tax rate of how much I can put in my plan. If you are not going to be able to max that out, that plan costs too much to own,” he says. That would be the “worst thing we could ever do for our retirement system.”
There are potential tax benefits for employers who offer defined contribution plans to employees because plan contributions for the business owner are deductible as a business expense. Business owners who start a new retirement plan receive a tax credit of up to $500 for certain expenses they incurred during startup and maintenance of their plan for the first three years they offer the plan.
Chairvolotti believes that instead of lowering deferral limits, Congress should raise the limits and give employers more incentives so they are willing to share more with their employees.