Tax Reform Proposal Alarms Retirement Industry

March 19, 2014 | By Jon Vogler

Rep. Dave Camp, R-Mich., chairman of the House Ways and Means Committee, released a comprehensive tax reform proposal on Feb. 26, 2014. The draft legislation aims to simplify the Internal Revenue Code by:

  • Reducing the current number of individual tax brackets from seven to three — 10%, 25% and 35%.
  • Reducing the corporate tax rate to a flat 25%, phased in over five years.
  • Eliminating or consolidating a number of individual and business deductions.

But numerous provisions that would affect the ability of individuals to save for retirement have set off alarm bells in the retirement industry. This edition of “Washington Insights” focuses on those provisions.

Frozen limits

Under current law, limits on contributions and benefits for qualified retirement plans are indexed for inflation. The Camp proposal would freeze these increases for 10 years, capping individual, or elective, salary deferrals to qualified retirement plans at $17,500 – or at $23,000 for those eligible to make catch-up contributions – for the next decade. Inflation indexing would resume in 2024, based on the frozen level.

The Roth treatment

For employers with more than 100 employees, the proposal would subject all elective deferrals into qualified retirement plans that are above 50% of current limits — $8,750, or $11,500 for individuals eligible to make catch-up contributions — to Roth tax treatment by taxing them up front rather than on distribution. (Employer contributions, however, would continue to be made to traditional, pretax accounts.) The Plan Sponsor Council of America (PSCA) issued a statement opposing this provision, noting that it would add complexity and increase administrative costs.1

In addition, the proposal would require all employers with more than 100 employees to amend their plan documents to allow employees to make Roth contributions, if not already permitted.

Income tax liability cap

The Camp proposal would cap the rate at which deductions and exclusions — including those related to retirement savings — reduce income tax liability at 25%, effectively subjecting taxpayers in the new 35% tax bracket to a 10% surtax on all employer and employee contributions. According to the Association of Pension Professionals & Actuaries (ASPPA), this provision would, in effect, tax contributions to qualified retirement plans twice:

  • Individuals, including small-business owners, would pay the 10% surtax when contributions are made to the plan.
  • They would then pay tax again at the full ordinary income tax rate when the money is distributed from the plan during retirement.2

ASPPA’s Executive Director and CEO Brian Graff noted, “Penalizing small-business owners for contributing to a plan is going to make them think twice about sponsoring a plan at all, and their employees could lose their workplace retirement plan as a result. Double taxation is hardly what we hoped to see in any tax reform proposal.”1 Mr. Graff characterizes this provision and the long-term freeze on contribution limits as “… a real blow to employer-sponsored retirement plans and to the retirement security of American workers.”2

Disappearing acts

Additional retirement-related changes ringing retirement alarms include:

  • Prohibiting new traditional IRA contributions. New contributions (not including rollovers) to traditional and nondeductible traditional IRAs would be prohibited after 2014. In conjunction with this change, the proposal would eliminate current income eligibility limits for contributing to Roth IRAs.
  • Freezing inflation adjustments on Roth IRA contributions. For tax years beginning after 2014, the inflation adjustment of the annual limit on Roth IRA contributions would be suspended until 2024.
  • Repealing traditional/Roth IRA recharacterizations. Current rules allowing for recharacterization of a contribution to a traditional IRA as a contribution to a Roth IRA (and vice versa) and recharacterization of a conversion of a traditional IRA to a Roth IRA would be repealed.
  • Repealing the 10% penalty exception for first-time homebuyers. The current exception to the 10% early withdrawal penalty for first-time homebuyers would be eliminated.
  • Eliminating new SEPs or SIMPLE 401(k)s. To simplify choices for establishing new retirement plans, new Simplified Employee Pension (SEP) IRAs or Savings Incentive Match Plan for Employees (SIMPLE) 401(k) plans would be eliminated after 2014. Existing SEPs and SIMPLE 401(k) plans would be grandfathered, while SIMPLE IRAs would still be available.

Distribution rule changes

Other changes proposed in the Camp bill would affect distributions, including:

  • Modifying required minimum distribution (RMD) rules. An account owner’s ability to “stretch” tax deferral on retirement savings well past death would be limited by requiring that the entire balance of an inherited IRA or employer-sponsored plan be distributed within five years after the IRA owner’s or employee’s death, regardless of whether the IRA owner or employee dies before RMDs have begun. The proposal includes an exception — for a beneficiary who is a spouse, disabled, chronically ill, not more than 10 years younger than the deceased or a child — that would permit distributions to begin within one year of death and be spread over the life expectancy of the beneficiary. However, if the beneficiary dies or a child beneficiary reaches age 21, the general five-year distribution rule would apply. While this proposal may ease plan administration and get more revenue into Treasury coffers sooner, it would eliminate an important estate planning opportunity.
  • Reducing minimum age for allowable in-service distributions. Under current law, defined contribution (DC) plans generally aren’t permitted to allow in-service distributions — while an employee is still working for the employer — attributable to tax-deferred contributions if the employee is younger than 59½. For state and local government DC plans and all defined benefit (DB) plans, the restriction on in-service distributions applies if the employee is younger than 62. Under the proposal, all DB plans, as well as state and local government DC plans, would be permitted to make in-service distributions beginning at age 59½ after 2014. The change is intended to encourage phased retirement and promote consistency among various types of retirement plans.
  • Modifying rules governing hardship distributions. The IRS hardship withdrawal safe harbor that requires employers to suspend employee deferrals for six months following a hardship distribution would be eliminated to encourage continued savings for retirement after a hardship withdrawal.
  • Extending the period for rollover of plan loan offset amounts in certain cases. Under current law, if a plan terminates or an employee’s employment terminates while a plan loan is outstanding, the employee has 60 days to contribute the loan balance to an IRA or the loan is treated as a distribution subject to taxes and penalties. Under the proposal, employees whose plan terminates or who separate from employment with plan loans outstanding would have until the due date for filing their tax return for that year to contribute the loan balance to an IRA to avoid taxation of the loan as a distribution.
  • Eliminating NUA in taxation of employer stock distributions. Under current law, if a participant receives a lump-sum distribution of all employer stock held in his account, the participant can exclude from taxation the value of the stock received that was attributable to the appreciation in the value of the stock while held in the plan – net unrealized appreciation, or NUA. When the stock is later sold, the NUA is realized as part of the capital gain in the stock. The proposal would eliminate the use of NUA in these distributions.
  • Extending uniform contribution limits for all DC plans. The same 401(k) limits on contributions would apply to 403(b) and government 457(b) plans, and the special catch-up types of contributions available under 403(b) and 457(b) plans would be eliminated, as would taxpayers’ ability to use multiple plans to increase the available limits.
  • Extending the 10% early withdrawal tax to government 457 plans. Participants in these plans would be subject to the 10% additional tax on early distributions, effective after Feb. 26, 2014.

2014: Revenue raising trumps tax reform?

Political commentators generally don’t expect tax reform legislation to be enacted in 2014. But because many of the above provisions – such as modifying RMD rules to limit "stretch" IRAs – would raise significant amounts of revenue for the Treasury, some could piggyback on other legislation. But here’s a certainty – partisan politics will characterize the heated debate to come over the long course of the tax-reform process.

Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. It was not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer under US federal tax laws. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation.

The opinions in this piece are those of the author and are not necessarily those of Invesco. Information in this report does not pertain to any Invesco product and is not a solicitation for any product.

1 Source: PlanSponsor, “Industry Groups Raising Alarms About Tax Reform,” Rebecca Moore, Feb. 27, 2014
2 Source: NAPA Net, “Camp’s Tax Reform Proposal Hits Retirement Savings Incentives,” Andrew Remo, Feb. 27, 2014