The recent tax reform proposal by the Trump administration may adversely affect the retirement plan industry. While details of the tax proposal haven’t been ironed out, two potential components have members of the retirement industry feeling uneasy: reduced pre-tax contribution limits and reduced tax on pass-through income for small-business owners.
Reduced Pretax Contribution Limits
The Trump administration has advertised that its tax reform blueprint will lower both personal income tax and corporate tax rates — goals the president reiterated throughout his campaign. However, doing so will require the government to fill the revenue gap these cuts create. The GOP has often put a target on tax spending for the pension industry. In 2015, tax expenditures for retirement savings exceeded $150 billion. That figure is expected to exceed $1 trillion from 2015 to 2019, according to the Tax Policy Center.
If Trump’s tax reform plan reduces pre-tax contribution limits for 401(k) retirement plans from the current cap of $18,000 to, say, $9,000, overall saving rates may fall. Such a change could undermine the incentive for employers to offer retirement plans and for employees to contribute.
Lower pre-tax contribution rates may also encourage “leakage” from retirement plans, as participants may be more likely to withdraw retirement savings for nonretirement purposes. Roth contributions permit withdrawal of principal at any time without penalty. (The IRS levies taxes and penalties on withdrawn investment returns until age 59½; after that age, all funds can be withdrawn penalty-free on accounts held for at least five years.)
Reduced Tax on Pass-Through Income for Small-Business Owners
If the Trump plan reduces the tax on pass-through income, the owners of pass-through entities, including partnerships, S Corporations, real estate investment trusts, and limited liability corporations — an estimated 90 percent of American businesses — may have less incentive to defer current income in the form of retirement plan contributions.
Proposals from both the House of Representatives and White House cap the tax rate on pass-through income and apply the ordinary income tax rate on distributions from qualified retirement plans. The difference in the tax rates for pass-through income and ordinary income tax rates for small-business owners could be significant. Some estimates show a difference as large as 10 percent to 20 percent.
U.S. Retirement Crisis on the Horizon
As members of the baby boom generation retire (the oldest are now 71), the nation is on the cusp of a retirement crisis. Fully 50 percent of those 76 million boomers have $100,000 or less saved for life after work. Retiring at the rate of 10,000 a day through at least 2030, individuals in this generation compose 20 percent of the U.S. population.
And millions of younger Americans may share an impoverished retirement with baby boomers. More than half of all U.S. workers — about 55 million — don’t have access to a workplace retirement plan. Most affected are those who work for small companies, many younger workers, minorities, and low- to moderate-income earners.
What Can Employers Do?
If the Trump administration’s tax reforms become reality, what can businesses do to help their workers prepare for retirement? The prospect of lower income tax rates poses an opportunity to sponsor a 401(k) savings plan that includes a Roth source.
A 401(k) with a Roth structure offers important benefits:
- Money grows tax-free, because contributions are funded with after-tax dollars. When participants withdraw funds at retirement, they pay no taxes.
- Contributions to the retirement account can be withdrawn without penalty at any time, for any reason, although investment earnings withdrawn before age 59½ will incur a penalty unless there’s a qualifying reason.
- Participants don’t have to make withdrawals by a specified age, and they can continue to contribute to the fund regardless of age.
For existing retirement plans that don’t currently allow Roth contributions, plan sponsors may want to consider adding a Roth feature to allow participants to make after-tax Roth contributions. This presents an opportunity for plan participants — and plan sponsors, as well.
Additionally, sponsors of workplace retirement plans may see value in adding an in-plan Roth conversion feature to allow participants to convert pre-tax deferrals to a Roth source. This will create a taxable event, but possibly at a lower tax rate under the Trump proposal. Notably, only 36 percent of 401(k) plans offer an in-plan Roth conversion, so adding this plan feature presents a great opportunity.
The current tax structure for retirement plans significantly benefits both small-business owners and plan participants. With the nation facing a retirement crisis, the Trump administration should recognize the consequences of creating a tax structure that discourages small companies from contributing to or sponsoring workplace retirement plans.
Paychex will continue to monitor the Trump administration’s tax reform proposal closely. We encourage tax advisers, investment advisers and small-business owners to follow the issue to understand its impact on small-business owners and their employees. Look to Paychex for industry-leading retirement solutions for companies of every size.