The Tax Cuts and Jobs Act of 2017 is a mixed bag for qualified retirement plans.
Robyn Credico, defined contribution practice leader, North America, with Willis Towers Watson in Arlington, Va., notes that, while several potentially disruptive proposals didn’t come to fruition, consultants and sponsors, can’t ignore the Act’s changes. “Ultimately, the actual final bill didn’t change that much when it came to retirement plans,” she says. “But I do think that consultants and wealth managers should be rethinking how plans are managed given the Act.”
One prominent potential modification being discussed before the Act’s passage was to change plan contributions from pretax income deferrals to nondeductible, after-tax Roth-type deferrals. The general sense among retirement professionals was that this change would reduce participants’ incentive to save, says Glenn Sulzer, senior analyst, corporate compliance division with Wolters Kluwer Legal & Regulatory U.S. in Riverwoods, Ill. Some behavioral economists believe inertia would lead participants to maintain their contribution rates regardless of deductibility, but that point is debatable, and the potential risk to retirement savings rates is significant. “It’s hard enough getting employees to defer when they get the tax break upfront,” Sulzer notes. “That’s why a lot of employers are going to automatic enrollment.”
The Act’s changes to marginal personal tax rates could actually make Roth plans more attractive, says Credico. An increased standard deduction and lower marginal rates mean many taxpayers will see a boost in take-home pay, potentially making Roth accounts more attractive as taxpayers can afford to save more. Increasing Roth contributions could improve participants’ retirement readiness, adds Credico. Although participation in available Roth options within plans has been relatively low, she believes this is a good time to remind participants about Roths and review “what’s best for them in their defined contribution plans from a tax perspective and the retirement readiness perspective.”
Loan Repayment Extension
According to Vanguard’s How America Saves 2017 report, 16 percent of plan participants had loans outstanding in 2016. Under previous law, if an employee with an outstanding loan balance left the plan or the plan terminated, the employee had 60 days to repay the loan by rolling over (and funding) the loan balance to an eligible retirement plan in order to avoid a substantial penalty. That usually meant depositing an amount equal to the loan balance in an IRA. (Technically, this is treated as rolling over a plan loan offset of the terminating participant’s outstanding loan balance.)
The Act extends the period for rolling over loan offset amounts. Effective for tax years starting after Dec. 31, 2017, the rollover deadline is now the deadline for filing an income tax return, including extensions, for the year in which the loan amount is treated as a distribution from the plan. There are still limits in place, Sulzer cautions. The change doesn’t apply to deemed distributions, such as a loan in default, and participants can take only one rollover every 12 months.
Pass-Through Deductions’ Impact Still Unclear
The Act has the potential to complicate retirement plan decisions for business owners operating as noncorporate entities. For example, owners of S corporations typically receive two types of compensation. Wage compensation is subject to applicable Social Security and Medicare taxes. Pass-through business income is not subject to these taxes.
However, only wage (i.e., earned) income is the basis for retirement plan contributions. As per the IRS:
“Contributions to a retirement plan can only be made from compensation, which, in the case of a self-employed individual, is earned income. Distributions you receive as a shareholder of an S corporation do not constitute earned income for retirement plan purposes.”
In a December 2017 white paper, Sulzer notes that for tax years 2018 through 2025, the Act allows noncorporate taxpayers to deduct up to “20 percent of domestic qualified business income from a partnership, S corporation or sole proprietorship,” subject to limitations.
One potential outcome of this change is that “small-business owners may now elect to pay tax on income at the lower pass-through rate, rather than contribute the income to a qualified plan,” Sulzer writes. This shift could result in owners deciding that it’s in their economic interest to avoid the cost and effort required to maintain a qualified retirement plan.
But this isn’t a foregone conclusion, Sulzer cautions. The pass-through rules are complicated and somewhat ambiguously written, so their ultimate impact is still unclear and dependent on a taxpayer’s situation. Also, tax considerations aren’t the only consideration driving small businesses’ use of retirement plans. While very small firms might be able to get away without offering a retirement plan, most businesses that have employees need to provide a plan to retain employees in a competitive labor market. Consequently, the Act’s pass-through provisions’ impact on retirement plans could be muted.