The Tax Cuts and Jobs Act made several changes to provisions affecting retirement plans and other employee benefits. While the changes involving retirement plans were not as sweeping as many had feared, they remain worthy of attention. The following is a summary of relevant changes:
Qualified Retirement Plans After Tax Reform
In any discussion of the effects of tax reform on qualified plans (e.g., pension and 401(k) plans), the provisions that were not included in the final version of the law are as important as the provisions that were included. Earlier versions of the bill included provisions that would have (a) limited pre-tax employee contributions to 401(k) plans to $2,400 per employee, as compared to the actual 2018 limits of $18,500 (for those under age 50) or $24,500 (for those over age 50), or (b) required all 401(k) contributions to be Roth contributions (resulting in current taxation of such contributions, but tax-free growth and eventual distribution). Since neither of these provisions survived to the final version of the law, however, retirement savings policy generally remains unchanged.
Indirectly, however, the advantages of maintaining a qualified plan are affected by tax reform in the following ways:
- When tax rates are lowered, the value of the tax deduction for contributions goes down. For example, assume that a small business owner was in the 39.6% tax bracket under prior law, but is in the 35% tax bracket under new law. If the owner contributed $100,000 to a qualified plan under prior law, he saved $39,600 in current taxes. Under the new law, the savings on the same $100,000 contribution will be limited to $35,000. The tax deduction is less valuable by $4,600.
- Under the new law, owners of pass-through entities (e.g., S corporations, partnerships, LLCs treated as partnerships, and sole proprietors) are entitled to a deduction equal to 20% of their “qualified business income.” Therefore, the effective tax rate in the above example is actually 28% (35% x 80%), reducing the tax benefit to $28,000, for a total difference of $11,600 ($39,600 – $28,000). Further, the benefit the owner accumulates in the qualified plan will eventually be taxed at ordinary income rates, with no reduction, upon distribution. These factors could serve as a disincentive for small business owners to maintain and contribute to qualified plans.
But the above analysis does not end the discussion. Several advantages to contributions to a tax-qualified plan remain:
- The above example assumes the same tax rate at the time of contribution and the time of distribution. However, many taxpayers are subject to a lower tax rate at the time of distribution (e.g., in their retirement years). This factor continues to point in favor of tax deferral, i.e., contributions to qualified plans.
- Some experts suggest that the most significant benefit of qualified plan contributions is not the value of the current tax exclusion; it is the value of the exemption from taxation of trust earnings within the plan, which remains in effect under the new law.
- As a general policy matter, saving for retirement remains important for both business owners and their employees.
- Qualified plans, particularly those with meaningful employer contributions, help business owners to attract and retain employees.
- Under federal law, qualified plan assets must be held in trust and are protected from the reach of creditors of both employers and employees.
- Saving in a qualified plan may help to avoid other taxes created by the new law, such as the limit of $10,000 on the deductibility of state and local income taxes.
- The deduction of 20% of qualified business income (QBI) described above is not available to business owners who (a) are in a “specified service trade or business” (e.g., health, law, consulting, athletics, financial services, or brokerage services, but not engineering or architecture), and (b) have taxable income in excess of $415,000 (for married taxpayers filing jointly) or $207,500 (for individual taxpayers). The deduction is phased out for individuals with taxable income in the $315,000 to $415,000 range (for married taxpayers filing jointly) or the $157,500 to $207,500 range (for individual taxpayers). Contributions to qualified plans reduce taxable income. Thus, a contribution to a qualified plan could actually make an otherwise ineligible business owner eligible for QBI treatment. For example, assume that a physician who is an owner in an S corporation has wages of $250,000, QBI of $200,000, and taxable income of $415,000. The physician is not entitled to any deduction based on QBI. If the physician contributes $100,000 to a cash balance pension plan, his taxable income would be reduced to $315,000. Assuming that the contribution comes out of the QBI, the remaining QBI would be $100,000, for which the physician would be entitled to a deduction of 20% ($20,000). So, the pension contribution would reduce taxable income by $120,000 ($100,000 + $20,000), $20,000 of which would be permanent. (The $100,000 contribution to the plan will eventually be taxed, upon distribution from the plan.)
In summary, the analysis of qualified plans after tax reform involves many factors and does not yield obvious answers. Business owners should contemplate changes only after careful consideration and advice from their accountants and other advisors.
Enhanced Employee Compensation and Benefits Tied to Lower Corporate Tax Rate
The new law lowered the corporate tax rate from 35% to 21%. While this change is not particularly meaningful for small businesses (which are typically organized as pass-through entities or which plan to minimize taxable income at the entity level), the change is very significant for larger corporations. Many larger corporations, such as Walmart, FedEx, AFLAC, Nationwide Insurance and Starbucks, have already announced increased compensation and benefits, including across-the-board raises, larger matching contributions to 401(k) plans, and increased employer contributions toward health insurance costs, all based on tax cut savings.
Impact of Repeal of Health Insurance Individual Mandate on Individual and Employer
Contrary to some reports, the tax reform law did not repeal the Affordable Care Act. However, it did eliminate the “individual mandate,” i.e., the requirement that all U.S. citizens have health insurance meeting certain minimum standards or pay a penalty for failing to do so. (Technically, the provision was not repealed, but the amount of the penalty was reduced to zero.) Unlike most of the provisions of the new law, which take effect immediately in 2018, this change is not effective until January 1, 2019, so individuals without coverage in 2018 will still have to pay the penalty ($695) for 2018.
The effects of this change are hard to predict. While some individuals will continue their existing coverage even without the mandate, others may drop their coverage, or choose less expensive coverage that does not meet the current minimum standards. While the government will not be collecting penalties for years after 2018, the change is actually projected to save taxpayers billions of dollars over the next 10 years, by simply reducing the number of individuals who purchase taxpayer-subsidized coverage in order to avoid the penalty.
The effects on employers are less direct but could be very real. The lack of an individual mandate could reduce the number of terminating employees who elect COBRA coverage. More significantly, the change could potentially make health insurance more expensive (for both employers and individuals) as an increased number of healthier individuals choose not to buy coverage and therefore remove themselves from risk pools.
Extended Rollover Period for Deemed Distributions of Retirement Plan Loans
Under prior law, when a participant in a 401(k) or other retirement plan defaulted on a loan from the plan, such as when the participant terminated employment with the plan sponsor, or the plan sponsor terminated the plan, the result was an “offset” treated as a distribution for tax purposes. The participant could avoid the tax bite by making a rollover contribution to an IRA within 60 days, but in most cases, the participant did not have liquid assets with which to make this contribution. (If the participant did have the liquid assets, he or she could have repaid the loan.)
The new law extends this rollover opportunity to the due date for the participant’s tax return for the tax year in which the deemed distribution is received. For example, suppose that an employer terminated its 401(k) plan effective December 31, 2017. On March 31, 2018, Mary receives a distribution of her vested account balance under the plan. At that time, Mary has an outstanding loan balance of $10,000. While Mary might not have the available cash to pay off her loan at that time, she will have until April 15, 2019 (or October 15, 2019 if her 2018 tax return is extended) to come up with the $10,000 and contribute it to an IRA. If she does so, no portion of the loan balance will be taxable.
While this change will be very helpful to employees affected by plan termination or termination of employment, it does not apply to other default situations, such as where a current employee in an ongoing plan simply becomes unable to continue making loan payments.
Repeal of Rule Permitting Recharacterization of Roth IRA Conversions
Under prior law, a taxpayer who made a contribution to a traditional IRA and then converted the IRA into a Roth IRA could later recharacterize the Roth IRA as a traditional IRA, provided that the transfer was completed by the due date for the taxpayer’s return for the year for which the contribution was made (including extensions). This election might be prudent, for example, where the value of the IRA declined significantly after the conversion.
The new law repeals the rule permitting the recharacterization of Roth conversions. Thus, while such conversions are still permitted, they can no longer be reversed. This change is effective for conversions made on or after January 1, 2018, however. Conversions made during 2017 can still be recharacterized, provided that the required action is taken by October 15, 2018.
Tax Relief for Retirement Plan Distributions in Disaster Areas
Generally, a distribution from a qualified retirement plan or an IRA is subject to a 10% penalty, in addition to ordinary income tax, if the recipient has not reached age 59½ at the time of the distribution.
The new law provides for several forms of relief in the case of “qualified 2016 disaster distributions” (defined to include distributions made during 2016 or 2017 to any individual who lived in a disaster area declared by the government and who sustained losses due to the disaster). First, the distribution is not subject to the 10% penalty. Second, the distribution may be included in the individual’s taxable income ratably over a period of 3 years, in lieu of being included entirely for the year of the distribution. Third, if the distribution is recontributed to an eligible retirement plan within 3 years, it is treated as a rollover and is not subject to any federal tax. (Refunds of taxes already paid can be claimed via the filing of amended returns for prior years.)
Employer Credit for Paid Family and Medical Leave
The Family and Medical Leave Act (FMLA) generally requires employers with at least 50 employees to provide up to 12 weeks of unpaid, job-protected leave for reasons such as childbirth or serious illness. Employers can elect to pay compensation to employees while they are on leave, but did not get a credit for such payments under prior law.
Under the new law, eligible employers (generally defined to mean employers that provide at least 2 weeks of paid leave) can claim a business credit equal to 12.5% of wages paid to employees on leave if the rate of payment is 50% of regular wages, increased by .25 percentage points (but not more than 25%) for each percentage point by which the rate of pay exceeds 50%. This provision is temporary, as the credit is only available in 2018 and 2019.
Transportation Fringe Benefits
Under prior law, qualified transportation fringe benefits (e.g., employer-provided transit passes, qualified parking expenses, and van pooling expenses) provided by an employer to an employee were excluded from the employee’s taxable income, and deductible by the employer.
While the tax exclusion for employees remains in effect under the new law, employers are not permitted to take a deduction for these expenses for any year after 2017. Employers will also have to pay FICA taxes on the value of the benefit. Depending in part on the value of the benefit to an employer’s workforce, and in light of the loss of the deduction, the employer will have to decide whether to continue this benefit.
Under prior law, an employee could claim a deduction for qualified moving expenses (generally, those expenses incurred in connection with starting a new job at least 50 miles farther from the employee’s former residence than the employee’s former worksite), and could exclude reimbursements paid by the employer for such expenses from taxable income.
The new law suspends the deduction and the exclusion, for the years 2018 through 2025, with an exception for members of the U.S. Armed Forces on active duty.