Some "Top of Mind" Thoughts on the Tax Reform Proposals
On November 2, 2017, the House released its version of a tax reform proposal, the Tax Cuts and Jobs Act. On November 9th, the Senate issued its markup of the Act, which was substantially different from the House version, particularly with respect to retirement plan changes. The next step will likely be to reconcile the two proposals into a single piece of legislation that the House and Senate could approve, and would ultimately be signed into law if the President approves. This edition of Top of Mind shares our initial impressions of the two bills.
House Version: Minimal Retirement Plan Impact
The big news from the House proposal was the lack of news regarding retirement plans. After much public discussion about reducing retirement plan contribution limits, it was not in the final bill.
However, there were some minor retirement plan related changes, including:
- Eliminating the ability to re-characterize traditional to Roth IRA conversions, or vice versa —Apparently, people were using this as a tax loophole. An example provided in the bill was someone converting to a Roth IRA, investing aggressively and benefiting from any gains (which are never subject to tax), and then retroactively reversing the conversion if the taxpayer suffered a loss, so as to avoid taxes on some or all of the converted amount. I believe that most people are probably okay with this change, except those taking advantage of it!
- \Allowing age 59 ½ in-service distributions in all retirement plans — Previously, defined benefit plans and state/local government defined contribution plans, unlike other plan types, could only permit in-service distributions upon attainment of age 62. This seemed like a silly rule, and I suspect most people would be glad to have it reduced to 59 ½.
- Directing the Treasury to eliminate the six-month suspension of elective deferrals following a hardship distribution — This has always been an administratively burdensome and unpopular rule, so good riddance to it as well.
- Allowing employers to permit hardship distributions of earnings, as well as employer contributions — Limiting hardship distributions to only elective deferrals (without earnings) has also been a difficult rule to administer and explain to participants. I suspect that many employers will continue to prohibit the in-service distribution of employer contributions to preserve retirement assets; however, with this change, they would have the option of using the same hardship rules that apply to elective deferrals (and now earnings). I don’t expect many objections to this change, either.
- Allowing employees the option to no longer be “stuck” for the taxes on outstanding loans upon termination of employment — Some retirement plans do not permit the continued repayment of loans following termination of employment; for those plans, the outstanding loan, unless offset by the participant’s account balance, will be taxable to the participant unless a contribution to an IRA is made within 60 days of termination of employment. The proposal extends this deadline to the due date of the tax return for the tax year of termination. This rule has always been a tough one for terminating employees, so the change should also be welcomed.
- Permitting more flexible nondiscrimination testing rules where both a defined contribution (DC) and a defined benefit (DB) plan are maintained by a plan sponsor — This is another change that should be well received. Since many employers in scenarios such as this have closed their DB plans to new entrants, it can be easy to run afoul with the existing nondiscrimination testing rules. Thus, in our opinion, the House bill proposed changes to retirement plan law, albeit minor, were largely positive. The Senate, well, not so much.
Senate Version: Significant Changes to 403(b), 457(b) and Nonqualified Plans
Unlike the House bill, the Senate markup adds some restrictive retirement plan rules that will primarily affect tax-exempt and governmental plan sponsors:
- Combining the 403(b)/401(k) elective deferral limit with the 457(b) limit —Instead of separate limits for these plans, the Senate proposed a single elective deferral limit beginning in 2018. This would effectively eliminate the use of 457(b) plans at tax-exempt organizations, such as colleges/universities and healthcare institutions, as well as at public school districts (state/local governments are largely unaffected, since they often offer 457(b) as standalone plans for elective deferrals). The reason for this is that the vast majority of these entities sponsor 403(b) or 401(k) plans alongside their 457(b) plans. With one elective deferral limit, it wouldn’t make sense to defer those dollars into a 457(b) plan instead of a 401(k) or 403(b) plan, so 457(b) plans would no longer be necessary. Now, to be fair to the Senate, I had written in last week's Top of Mind that the lofty separate limits for 403(b)/401(k) and 457(b) were ripe for reduction (I suggested a combined $25,000 limit), but eliminating the extra deferral opportunity entirely, effectively doing away with 457(b) plans, seems excessive.
- Eliminating the separate 415 limits when a plan sponsor establishes both a 403(b) and a 401(a) plan — Again, this limit was ripe for reduction, but eliminating the separate limit entirely seems to be extreme. This change would result in many affected plan sponsors ditching their 401(a) plans, since the separate limit is likely the primary reason for the 401(a) plan’s existence.
- Eliminating the 3-year catch-up for 457(b) plans — We can live with this change, since so few people actually use it.
- Eliminating the rule that allowed for contributions to a 403(b) plan for up to 5 years after retirement — We hate to see this one go, but again, the utilization was quite low.
- Eliminating the 15-year catch-up election for 403(b) plans, which permits additional elective deferrals to 403(b) plans for certain employees — Now we’re talking, Senate! In my opinion, this awful tax rule was my number one target for elimination. I am delighted to see it go!
Although we can begrudgingly accept the Senate’s proposed changes, it appears that many will negatively affect tax-exempt/governmental plan sponsors, which is a bit of a disappointment. The reason that many of these tax benefits exist in the first place is that these employers often have difficulty attracting and retaining talent, since they often do not pay as much as private sector employers. These changes, should they become law, will likely only worsen the problem.
In addition to targeting 403(b) and 457(b) plans, nonqualified deferred compensation plans were a focal point of the Senate markup (the House also targeted these as well, but their bill was later amended to remove any reference).
Under current law, there is a disparity between plans for private tax-exempt organizations and their corporate counterparts. Tax-exempt deferred compensation plans, otherwise known as 457(f) plans, can only avoid current taxation if the amounts deferred are subject to a substantial risk of forfeiture (e.g., substantial future services must be performed in order for the employee to not be immediately taxed on the compensation deferred). That is why these plans are rarely used for elective deferrals, and, in the nonprofit sector, are often not used at all. Corporate plans, however, have no such restriction, so elective deferral plans are common place.
Now, one might think that because of the attraction/retention problem described above, tax reform would include a rule eliminating the disparity between tax-exempt and corporate plans, so that there is no substantial risk of forfeiture rules for any nonqualified plans. However, the Senate is proposing the OPPOSITE approach: in that ALL plans, including corporate plans, contain a substantial risk of forfeiture rule. Thus, if this provision becomes law, corporate nonqualified deferred compensation plans are about to become a lot less common, and these plans will maintain their lack of utility at tax-exempt organizations. In a word: Ugh!
Finally, as if this weren’t enough, the Senate also decided to add a number of additional restrictions that were not in the House bill:
- Imposition of the same 10% premature distribution tax for 457(b) plans that currently applies to 403(b)/401(k) plans — This eliminates one of the primary advantages of 457(b) plans, making them less attractive than they already were.
- Elimination of the age-50 catch-up for those who received more than $500,000 in wages in the prior tax year — This would be a tough provision to administer, since it would presumably include wages for all employers of the employee, not just the plan sponsor.
- The substantial risk of forfeiture rules described above would apply to private tax-exempt 457(b) plans as well — The use of private tax-exempt 457(b) plans was effectively eliminated by the proposed combined 403(b)/457(b) limit described above; therefore, I am almost thinking that some 457(b) lobbyist must have annoyed the wrong Senator…
So, in summary, the House proposal sounded good for retirement, but the Senate proposal, quite the opposite.
Editor’s Note: Though this blog entry was published on November 16, 2017, it was written on November 10th, so any amendments to the proposals since that time may not be reflected.
Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.
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