One of President Trump’s primary objectives for his first year in office was comprehensive tax reform. In April 2017, the White House released an initial tax plan that suggested removal of all individual deductions except for mortgage interest and charitable donations. Later, the Trump Administration clarified that it would also keep the deduction for tax deferred retirement contribution; however, there continues to be inconsistency in messaging from the White House and details of the White House proposal are scarce. Based on previous Republican proposals, a plan for comprehensive tax reform is likely to focus on reducing marginal tax rates, reducing the number of tax brackets, and limiting deductions and tax credits.
Background. Any time tax reform is discussed, retirement plans are a part of that discussion because of how the government scores proposals, using a 10-year time frame. While traditional retirement plan contributions serve to defer the taxes until retirement, in most cases, those taxes are deferred past the 10-year budget scoring window. As a result, the budget score shows retirement plan contributions as a large tax expenditure, with the U.S. Treasury reporting it at more than $100 billion annually. The largest tax expenditures are for health insurance and mortgage interest. In contrast to retirement contributions, these expenditures permanently reduce government receipts rather than defer them to the future.
As Congress looks to reform the tax code and potentially reduce taxes, they must grapple with how the scoring will impact the federal deficit and the long-term impact on the federal debt. This is where retirement plans come into play. One way to offset the reduction in tax rates is to limit large deductions, such as retirement plan contributions. This could be done in one of two ways, to varying degrees of extremity.
Two Options. First, some or all, employee deferrals could be mandated to be Roth contributions. Roth contributions are not tax deductible when they are made and the tax benefit is achieved down the road in retirement when withdrawals are made tax-free. Because the benefit will typically occur past the 10-year budget window, this approach looks attractive to budget planners that are focused on the 10-year budget score. In this scenario, employer contributions would likely continue to be tax-deductible in the year they were made with income taxes due upon withdrawal in retirement, in order to encourage ongoing employer contributions.
Second, the deductions could be limited to lower tax bracket rates. Because the current tax system uses graduated rates and retirement plan contributions reduce marginal income, the greatest tax benefits go to those in the highest income brackets. High-income earners receive a greater tax benefit from contributing to their retirement plan than low-income workers because they are in a tax bracket with a higher marginal rate. Because of this, one option would be to limit the deduction to a lower marginal benefit. If that was done, everyone would receive the same, lower level of tax benefit for saving into their retirement account. This approach is likely to raise less in tax revenue than a full or partial Roth mandate but is still an option that could be considered.
Retirement Industry Perspectives. Many in the retirement industry are concerned about any changes to the tax code that would make saving for retirement more challenging for individuals. Right now, it appears that there is a lot of discussion about the “Roth-ification” of retirement plans, as it helps with the current deficit. The concern among many is that without the immediate incentive of a tax deduction, employees will save even less for their retirement, forcing everyone to fall further behind in terms of retirement security.
Ultimately, comprehensive tax reform is not an easy thing to accomplish, even with a Congress and executive branch controlled by the same party. It remains to be seen what, if anything, will be proposed and how it would impact retirement plans. If tax reform moves ahead it is worth monitoring to see what, if any, impact it will have on retirement policy.
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