Saving for retirement likely to be harder for small-business owners under tax reform

Take steps to accelerate retirement plan contributions before the enactment of new limits, taxes and rules.

The swearing in of America’s 114th Congress in January will increase the likelihood of tax reform sometime in the next few years. One possible outcome is the enactment of new revenue-raising initiatives that could make it harder for business owners to save for retirement.

Financial advisers and their clients who sponsor 401(k) and other defined-contribution retirement plans should evaluate whether or not current proposals would affect their retirement plans. You also should consider available strategies to mitigate the impact of regulatory changes or increase savings before potential new limits are enacted.

Budget hawks have been eyeing what the Congressional Budget Office projects is $414 billion in federal tax revenue lost to DC plans in 2015-19. The loss stems from contributions made on a pretax basis and earnings that are tax-deferred. Although these monies would be subject to tax once they are withdrawn by retirees, these future revenues are essentially invisible to federal budget makers who view the world through a 10-year window.

One proposal now before Congress would lower the cap on annual contributions by retirement plan participants, now scheduled as $18,000 in 2015, plus another $6,000 for those age 50 or older. Lowering the caps would generate more tax revenue, but also could make it harder to save for retirement.

TIGHTER LIMITS

Another revenue-raising proposal would place tighter limits on tax deductions taken by small-business owners for contributions made on behalf of employees to a retirement plan. One proposal, for instance, would limit the value of an individual taxpayer’s deduction to 28% during the taxable year. This provision could have a potential negative impact on small-business owners and plan -formation.

A less onerous proposal would merely freeze the contribution limits that apply to DC plans until 2024. After that, the limits would rise to track the cost of living. Under this same proposal, however, the allowable pretax contributions by participants would be cut in half, with the remainder made as Roth or after-tax contributions.

While it’s uncertain whether or not these proposals and others will become law, the smart money says you and your clients should hedge your bets. Business owners who sponsor 401(k) or other retirement savings plans should evaluate advanced plan designs that could enable them to save as much as possible before new restrictions on plan contributions take effect.

Many employers sponsor 401(k)s with a simple profit-sharing plan design and typically make contributions on behalf of all employees — including the owner and key executives — as an equal percentage of each employee’s salary. However, some advanced plan designs permit bigger contributions on behalf of business owners and key employees. The contributions can be based on criteria such as age, compensation or the Social Security wage base.

One way to mitigate the impact of congressional tax reform targeting defined-contribution retirement plans is to establish a cash balance plan — a defined-benefit plan that has become increasingly popular with professional firms. Cash balance plans, which can stand alone or complement defined-contribution plans, allow significantly higher contributions and tax deductions compared with those allowed by defined-contribution plans. However, small-business owners should know that cash balance plans are complex and require the assistance of legal and tax advisers, and third-party administrators.

ADVANCED DESIGNS

Meanwhile, two advanced designs for DC plans — integrated plans and new comparability plans — currently enable business owners to earmark a higher percentage of contributions to themselves, as much as $53,000 in 2015.

An integrated plan permits business owners to make larger contributions on behalf of employees whose earnings exceed a specific ceiling, typically the $118,500 Social Security wage base for 2015. Integrated plans work best when the business owner’s compensation is much higher than his or her employees’.

If there is a considerable difference between compensation, age and other variables between the owner and other employees, a new comparability plan might make sense. These plans divide employees into different groups with separate discrimination testing, therefore allowing disparities between contributions to each group. For instance, an employer making $265,000 annually could contribute $53,000 on behalf of himself or herself while contributing a minimum of at least 5% for lesser-paid employees.

Plan providers or third-party administrators can provide in-depth education and support on plan design concepts, formulas and execution.

Whether the new Congress will pass legislation limiting retirement plan contributions remains to be seen. It will take determined inactivity for the 114th Congress to surpass its predecessor in reaching new lows of legislative action.

All of this leaves you and your clients who own businesses a choice: You can either hope the new Congress endures more gridlock than beltway traffic, or you can take steps to accelerate retirement plan contributions before the enactment of new limits, taxes and rules. For those who aspire to a comfortable retirement, there is no debate.

E. Thomas Foster Jr. is assistant vice president of strategy and relationships for MassMutual Retirement Services, a division of Massachusetts Mutual Life Insurance Co. Inc.